Be Water

Be Water

Having covered Japan and bonds, I suppose I should go over the third risk I’ve talked about, liquidity.

Liquidity is actually a pretty complicated subject, because it means different things in different areas. There’s the balance sheet liquidity of central banks that’s been talked about quite a bit over the last year. There’s order book liquidity showing how easy it is to transact in volume in markets. In my mind, there are a large variety of ways to look at liquidity in different ways, and many of them are useful for different purposes.

For better or worse, I’m going to avoid going through that level of detail, as I try to keep these blogs fairly high level. Instead, I just want to point out that we’re going from what by some measures was surprisingly good liquidity to poor liquidity.

The chart below is important because it shows that the government is moving from being a provider of liquidity to a taker of liquidity. According to Laduc Trading, that’s going to be pretty evident over the next five weeks, as the Treasury General Account (TGA) is going to be filled by $335B. That’s money that will get sucked out of the market and given to the government, the opposite of what we saw for much of the start of the year.

How big of a problem is that? It’s always hard to say, as there’s never one single factor that determines market direction. I do have to admit I’m bothered by what seems like a very unconcerned stance by the market, though. It sure seems like the year-to-date has people in a buy-the-dip mentality. For much of the year, we’ve had stacking benefits, with friendly liquidity, a better-than-expected economy, and improving inflation. What if the stack of benefits turns into a stack of problems?

We already know that liquidity is likely to get worse. Can the economy get worse? Of course. Credit is tightening and leading indicators are getting worse. While the last CPI report was higher month-over-month, it was largely shrugged off, as it wasn’t as bad as feared. The next report, however, is expected to accelerate inflation back to 3.8%, at least according to the Cleveland Fed.

Outside of those broad factors, it seems like the market had priced in a very good set of outcomes. The Fed seems to have finally gotten through to the bond market, with longer rates going back to levels not seen since 2008, but the stock market has been far more stubborn.

Here’s a rough example of a bad scenario. Some basic, recent trends continue, such as JGBs walking towards a 1% yield, other sovereign bonds following along, and the dollar rising. China continues to struggle. All this keeps stocks trending down and volatility up, which turns systematic buyers into sellers. NVidia reports on Wednesday. If they disappoint significantly, that dashes a lot of tech hopes. The Fed’s Jackson Hole symposium starts the next day, and that gets a bad reception like the latest FOMC minutes. Maybe some economic data starts disappointing.

As we move into September, we get the CPI report on the 13th, which seems likely to be bad. A week later, we get the FOMC meeting, which would likely be a hike after a bad inflation report. In between those two events, we have a big quarterly OpEx, which can exacerbate volatility.

The thing is the market can be very reflexive. We spent most of this year watching inflows beget more inflows. That train can reverse. If liquidity reverses, a big spring of flows goes away. If yields and the dollar continue higher, if higher-for-longer positioning becomes more accepted, positioning can get more cautious. A lot of the positives we’ve seen can turn into negatives.

Potentially, that can get bad, quickly. If some potential events can start to really spike volatility and drop stocks, structured products may start getting closer to the limits they set, which could cause more hedging and more downside, basically in a gentler version of 1987.

I’m definitely not saying something like that is going to happen, just that there’s little hedging of that sort of tail risk event. In turn, that makes it easier to happen. Let’s say there’s a 10% chance something along those lines can happen, but the market is pricing in a 1% chance. In that case, buying some of that scenario makes sense.

Lastly, if something like that did happen, and the S&P 500 dropped something like 25%, that is a situation where you have to start thinking the Fed would formally announce a pause to hiking. Thus, assuming the job market and economy haven’t totally fallen apart, you’d probably want to be a buyer of stocks.

I know this blog wandered some, but my basic point is that big liquidity changes can be very important. We seem to have entered a change around the start of August and that seems likely to be felt through the rest of the quarter, at least. While bond and FX markets have started to price in concerns, the stock market has been relatively slow to get more conservative. In that situation, shocks have the potential to take a lot of damage, and we at least need to be prepared for that possibility.

I’m just going to take this day by day, week by week. There’s enough of import going on right now that my current plan is to see what happens this week and we can reassess after that. We’ll see what the world looks like in a week.