The Era of Easy Money Is Over and Liquidity Is Tightening: What Do You Want to Do?
Friday after the market closes is always an exciting time for me
because that's when the
data on commercial banking assets and liabilities is released. The
data has a one week lag, but it represents a fairly up-to-date
picture of lending activity. Friday's release was for the week
ending August 14 and showed that total banking credit declined by
$6.4 billion on the week with loans and leases declining by $10.6
billion. This decline in credit creation during the dog days of
summer should not be, in and of itself, too troubling, but it is
consistent with an emerging trend of decelerating credit growth.
Total bank credit is comprised of two main categories: loans and leases, and securities. A bank can make a loan or buy a bond. In January, total bank credit was $9.979 trillion of which total loans and leases represented $7.25 trillion and securities represented $2.73 trillion. The week ending August 14, total bank credit was a mere $9.984 trillion with loans and leases up to $7.295 trillion and securities at $2.688 trillion. So basically, in the last six months, you have total bank credit down $4.8 billion with loans and leases up only $46.7 billion and securities down $41.8 billion.
Commercial Bank Credit Vs. Loans and Leases
Credit growth, which is consistent with nominal GDP growth, has only grown by $167.6 billion over the past 12 months at a 2.35% pace year-over-year and is thus far negative on the quarter after Q2 posted the slowest pace of NGDP growth since emerging from recession. To give you an idea of how weak this credit growth is, in the same period a year ago, loans and leases grew by $323.4 billion at 4.75% YoY growth rate. The demand for money is decelerating.
Over this time period the Fed has pumped $500 billion into the financial system, so you would expect some of this to show up in bank credit. It hasn't. This suggests it's all in the bond market, which means that a lot of it has been vaporized by the recent meltdown. It's amazing how fast the market can eliminate excess liquidity. This is why tapering is tightening, and this excess liquidity removal is also why real yields are rising and the dollar is strengthening.
The Monday after Ben Bernanke top-ticked the stock market at his May 22 Congressional testimony, I wrote in Bernanke's Worst Nightmare: Rising Real Interest Rates :
Participants in the equity market obviously do not realize that the QE negative interest rate wind at their back is no longer present. Just as El-Erian implies, they have fallen prey to the illusion of QE stimulus via rising equity prices. In reality, the price of gold -- and more importantly, real interest rates -- are actually reflective of tightening monetary conditions. Perhaps Wednesday's capitulation flush reversal was indicative that the equity market is finally getting the message.
I was partly right and partly wrong. Some equity market participants did get the message, but others did not.
Each week BAML puts out a very insightful research piece that discloses its institutional (real money), hedge fund (levered money), and private client (retail) flows in and out of the stock market. Institutions are the smart money, hedge funds are the manic money, and retail is the dumb money. Since BAML is the largest brokerage network and does business with virtually every institution, its flows can be seen as a proxy for the entire market.
In Q1 2013 private clients were pretty consistent buyers of equity exposure, but toward the end of the quarter and into Q2, turned net sellers. By the week of May 6, with the S&P 500 (INDEXSP:.INX) crossing 1600, Private Clients had sold $619 million with the 4-week average negative $544 million, the 12-week average negative $257 million, and 52-week average negative $162 million. The week of May 27, just after Bernanke top-ticked the market, Private Clients turned net buyers, increasing equity exposure by $112 billion.
This past week's BAML Equity Client Flow Trend report was titled "Private Clients' Net Buying Streak Is Now the Longest on Record" (data since January 2008). It stated:
Private clients were net buyers for the twelfth consecutive week -- the longest buying streak in the history of our data (since 2008). Private clients have been the only group that has remained confident in the rally as the S&P 500 has continued to make new highs.
For the week ended August 12, BAML Private Clients bought $995 million, moving their 4-week average to $447 million and their 12-week average to $687 million, with their 52-week average finally turning net positive at $6 million. That same week Institutions sold $1.38 billion with their 4-week average at negative $308 million and 12-week average at $539 million. Since turning net buyers the week after Bernanke top-ticked the market, Private Clients have accumulated a net long exposure of $8.2 billion while Institutions have reduced exposure by $6.57 billion. For the past three months with the S&P 500 trading sideways at new all-time highs, the ownership of this market is changing hands. This is not a coincidence.
Smart Money Flow Index Vs. 10-Year Yield
The Bloomberg Smart Money Flow Index (SMFI) is designed to gauge how "smart money" is trading the Dow Jones Industrials (INDEXDJX:.DJI). The index uses simple methodology, assuming dumb money acts emotional and gives orders at the open while smart money waits until the close. According to Bloomberg:
To replicate this index, just start at any given day, subtract the price of the Dow at 10 a.m. from the previous day's close and add today's closing price. Whenever the Dow makes a high which is not confirmed by the SMFI there is trouble ahead.
You can see that the SMFI and DJIA are highly diverged right now and have been since -- you guessed it, the week of May 27. There is a reason for this divergence. Institutions are selling because interest rates are rising and liquidity has evaporated. Once the 10-year took out 2% to the upside, the smart money has been consistently fading this rally.
My guess is this is not random, but their models are telling them to sell due to higher discount rates. The cost of debt capital is rising and these institutions are discounting a higher cost of equity capital which translates into a lower multiple. They are selling because of the math.
One of the most consistent themes that arises when I talk to one of my Private Client advisor friends is that their customers are dying for more equity market exposure. The retail propaganda machine on TV is pumping at full throttle and it's tough to filter the noise. The ones who try to be prudent are under significant pressure to be reckless, or worse, are getting fired for not being so. This is because it is so painful to have liquidity. Zero interest rates and QE have driven cash holders to the brink of insanity, and since stocks broke out to new highs, retail is finally capitulating.
GDP growth is slowing, credit growth is slowing, corporate earnings are flat, the bond market is blowing up, the emerging markets have been massacred, the central bank is exiting stimulus, and we have no clue who is going to be the next Fed chairman. This has all developed over the past few months. But these economic and market risks don't compare to what may be coming to a money market near you. In Wednesday's release of the August Fed minutes they dropped a bomb that has garnered scant attention:
In support of the Committee's longer-run planning for improvements in the implementation of monetary policy, the Desk report also included a briefing on the potential for establishing a fixed-rate, full-allotment overnight reverse repurchase agreement facility as an additional tool for managing money market interest rates.
The presentation suggested that such a facility would allow the Committee to offer an overnight, risk-free instrument directly to a relatively wide range of market participants, perhaps complementing the payment of interest on excess reserves held by banks and thereby improving the Committee's ability to keep short-term market rates at levels that it deems appropriate to achieve its macroeconomic objectives.
The key term is "wide range of market participants." Who are these participants? Money market funds? Municipalities? General Motors ( GM ) or General Electric ( GE )? What about Google ( GOOG )?
Veteran trader Kevin Ferry of Cronus Futures, who knows a thing or two about the money markets, characterized the reverse repo facility as The Fed Builds The Death Star :
This nasty beast would attempt to suck up money from massive
pools after three years of tri-party reverse repo tinkering proved
futile and too risky for
Unlike George Lucas, Ben, and more importantly the Sith Lord to be named soon, cannot start at episode four. But build it they must. After all there's all that "money they printed" out there beyond the moons of Nobu. Spoiler alert - this system seizes up faster than the Millennium Falcon trying to make the jump to light speed.
If there is no liquidity today, what's it going to be like when the Fed, potentially competing with the banking system, is mopping up hundreds of billions in reverse repos? We may not know what this thing will look like, but the bond market has already responded.
The eurodollar curve for 3-month LIBOR futures, which had already been ransacked by the negative convexity blowout in May and June, is trading like a casino on LSD with dislocations in the curve never seen before. William Naphin, eurodollar trader for ICAP, sent a note out on Thursday titled, "There's simply epic stuff going on in the euro$ curvature today":
It may have quieted in tsys today with a short term range established and vol more or less back to unch (fv still warm), but the money curve is bending hard.
This is not Monopoly money were playing with, Valentine. This market trades trillions. The eurodollar pit is the deepest and most liquid market in the world. Pay attention.
The 5-year Treasury yield took out 1.60% (nearly where the 10-year was in May) while the 30-year rallied, narrowing the spread 15bps on the week. The market is telling you something. The excess liquidity that was a product of QE and has been the support for risk assets for four years is a thing of the past. That great big sucking sound is the Fed's excess liquidity vaporizing. It seems the institutions get this, but retail is oblivious.
From where I'm sitting the markets from Brazil to China to Chicago are saying the same thing. The era of easy money is over, and liquidity is tightening. How this tightening manifests in risk valuation is anyone's guess. The smart money is raising liquidity and the dumb money is providing it. What do you want to do?