Many times I have commented about the lack of liquidity in the markets, the result of regulatory fiat, changes in market trading structures and the massive move to passive investing.

Yesterday both Goldman Sachs and State Street echoed similar concerns, stating the issues in the repo market are perhaps the proverbial canary in the coal mine.  Both firms cited the systemic risk is partially the result of the end user of liquidity is now the customer who historically disappears in times of volatility.

In my view State Street’s warning is significant given that they are one of the largest custodians of ETFs.

In times of volatility, State Street and its customers may need to rely upon credit lines to meet ETF liquidation requests.  Such requests have caused several marquee European and South Korean investment firms to cease operations.  [Note:  These failures are the result of liquidity mismatches and illiquid investments]

A possible catalyst for such difficulties could be higher interest rates.  The bond market has discounted a recession.  The recessionary narrative is beyond fevered, the result of trade issues. What happens if the narrative is wrong?

According to Bloomberg analytics, if the 10-year Treasury increases in yield to where it stood on January 2, 2019, the 10-year would have a negative 22.24% total annual return.

Wow!  The risk free benchmark would be crushed.

In my view, from the perspective of US economic growth, the relationship with China is receiving too much attention.  Even before the trade dispute started, US exports to China were a smaller share of GDP than exports to Japan before the Japanese economy imploded in the early 1990s.

I vividly recall reading stories similar to the ones written today about China.  The US economy did very well.

Many have attempted to compare today to the 1930s.  According to Dow Jones, US merchandize imports dropped 70% from 1929 to 1932 and exports dropped 69%.

By contrast, even before the recent trade deals with Mexico, Canada and Japan being implemented US trade with the rest of the world has been rising.  Dow Jones reports in the past 12 months, exports and imports combined have been $5.65 trillion versus $5.63 trillion in calendar 2018 and $5.26 trillion in 2017 and $4.93 trillion in 2016.

In other word even without deals, trade would be hitting record highs this year.

The economic uncertainty is based on trade.  What happens to the bond market if this uncertainty is removed or if the reality that I have just penned becomes the prevailing narrative?

Perhaps we will discover if State Street’s and Goldman’s warning were indeed valid.

Commenting about yesterday’s market action, equities advance on trade optimism.  Earnings season accelerate today and results to date have been regarded as “mixed.”

Last night the foreign markets were up.  London was up 0.37%, Paris up 0.03% and Frankfurt up 0.22%.  China was up 0.50%,  Japan up 0.25%  and Hang Sang up 0.23%.

The Dow should open flat ahead of numerous earnings.  Trade optimism is also rising.  The 10-year is up 6/32 to yield 1.78%.


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.