Many times, I have commented about liquidity issues and how it relates to the repo market.  As widely discussed the Fed is intervening into the “plumbing of the markets” on a daily basis since September when yields spiked to almost 10%, acting as the bankers’ banker to provide necessary liquidity.

This was the first intervention since September 2008.  The Fed has been successful as rates are around the overnight targeted rate but the question as to why there is a liquidity issue is still at hand.

Friday Bloomberg wrote a provocative story validating some of my views.  Bloomberg writes the Fed had four choices, and two of the choices are perhaps reason for the liquidity crisis.

    1. Do nothing and let yields spike to 8%-10% and let the free market resolve issues.
    2. Change the number of days regarding the amount of reserves banks are required to have on hand from 30 days to 20 days.  These additional reserve requirements are the result of Dodd Frank
    3. Permit hedge funds and “other investment vehicles” to flounder and perhaps fail as liquidity demands swamped the ability to raise liquidity via the sale of “illiquid investments and the unwinding of very crowded trades.”
    4. Intervene in a similar manner as QE but don’t call it QE.

Obviously, the Federal Reserve chose number 4.

As written a gazillion times the markets are entirely dominated by passive and algorithmic/momentum trading.  A primary variable of these technology-based trading systems is interest rates.

There is a generational old adage of “don’t fight the Fed,” an axiom that is imbedded in these algorithms.

Since the Fed commenced its intervention in September the S & P has rallied over 17% with the largest capitalized issues leading.  As widely noted, five companies now comprise over 18% of the S & P 500, up from about 11% three years ago, shattering the 2000 record for the concentration of wealth in a handful of companies.  There are now four companies worth over $1 trillion, a feat that three years ago was deemed as improbable.

I rhetorically ask what happens if the Fed begins to shrink its balance sheet as was the case in February and December 2018?  Markets swooned at those times.

As noted the markets are dominated by the axiom don’t fight the Fed.  Will the outcome be amplified because the end user that is providing liquidity is the customer not a money center bank where fear is stronger than greed?  Passive investment now comprise about 55% of equity assets.

Unfortunately, if we use 2018 and 2012 as proxies the answer is yes.

I have consistently opined economic growth will be stronger than expected, a view that has come to pass.  The Federal Reserve has consistently stated the data will dictate policy.  The federal debt is massive, over $22 trillion thus stating demand for monies is gargantuan.  The Fed can not risk losing the confidence of the markets via a rise in inflationary expectations.  Such would crush Treasury and debt prices.

Will the Fed be forced to change monetary policy direction because of stronger than expected growth to maintain this confidence?

I place the odds at 50% which in turn could increase equity volatility.

If this does occur January 2020 is perhaps similar to that of January 2018.

What will happen this week?  Earnings seasons accelerates.  There is the Davos Economic summit and several housing statistics as will the Index of Leading Economic Indicators and other manufacturing statistics.  How will such influence trading and outlooks?

Last night the foreign markets were down.   London was down 0.83%, Paris down 0.72% and Frankfurt down 0.14%.  China was down 1.41%, Japan down 0.91% and Hang Sang down 2.81%.

The Dow should open nominally lower on worries about a deadly virus in China.  The 10-year is up  6/32 to yield 1.80%.


The views expressed herein are those of Kent Engelke and do not necessarily reflect those of Capitol Securities Management. Any opinions expressed are statements of judgment on this date and are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated or projected. Any future dividends, interest, yields and event dates listed may be subject to change. An investor cannot invest in an index, and its returns are not indicative of the performance of any specific investment. Past performance is not indicative of future results. This material is being provided for informational purposes only. Any information should not be deemed a recommendation to buy, hold or sell any security. Certain information has been obtained from third-party sources we consider reliable, but we do not guarantee that such information is accurate or complete. This report is not a complete description of the securities, markets, or developments referred to in this material and does not include all available data necessary for making an investment decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. If you would like to unsubscribe from this e-mail distribution, please reply to this e-mail and indicate that you wish to unsubscribe in your response.