Stocks Flounder as a Potential Liquidity Crisis Unfolds
Something that has yet to be fully documented happened in the financial markets around Valentine’s Day, which has severely hampered the market’s liquidity and increasingly put stocks under pressure.
The market’s decline on 2/21/22 was significant but not necessarily surprising given the action in the bond market that preceded it.
Nevertheless, unless the current action is reversed fairly quickly, stock prices could head decisively lower in a hurry.
I turned bullish on stocks near the October 2022 bottom and I based most of my bullishness both on the fact that everyone was bearish as much as on the fact that there was an improvement in liquidity in the market. However, as I noted in this prior post, I have had some concerns about the potential for problems in the commercial real estate market of late and the possibility that they could spread to other areas of the financial system.
Specifically I noted that as people leave “blue states” the potential tenant pool for commercial venues such as malls and office buildings is reduced. That reduction leads to a situation best summed up by the following thought also expressed in that post: “Without tenants, it’s hard to make mortgage payments.”
All of which brings me to the central tenet of the global economy: liquidity.
Liquidity, in the context of markets, is the amount of money that is available in the financial system to purchase assets once all other expenses are covered. In our neck of the woods, these assets are stocks. When there is enough money in the banking system after Wall Street and related entities pay their bills, liquidity is considered adequate enough to buy stocks.
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When the Federal Reserve lowers interest rates and buys Treasury bonds, it increases liquidity in the banking system. During periods of adequate liquidity, banks, brokerages, hedge funds, and private equity firms have excess money on their balance sheet which they often deploy into stocks.
There are many ways to quantify liquidity indirectly such as when we see rising asset prices. In this case, the rise in price and the generally smooth operation of the financial system is a sign that liquidity is at least adequate enough to conduct normal business.
A more precise way to measure liquidity is by combining two reliable indicators, the U.S. Ten Year Note yield (TNX) and the Eurodollar Index (XED).
Bonds and Eurodollars
There are two bellwethers for the stock market liquidity, U.S. Treasury bond yields, such as TNX and the Eurodollar Index, which is a more exact confirmatory instrument of what goes on in bonds.
Whereas rising bond yields are an indication of the market’s concerns about inflation as well as an indication of whether the Fed is injecting money into the banking system, the Eurodollar Index is a more direct measure of liquidity.
Simply stated, the Eurodollar system is made up of all dollar denominated bank deposits not held in the U.S. Thus, Eurodollars are not regulated by the Fed. This lack of regulation makes them ideal for international deals that need to close fast as well as to feed capital that goes into the stock market.
So, when T-bond yields rise, we should look to the Eurodollar Index for confirmation of what the rise in bond yields means in practical terms as an indicator of liquidity to buy stocks.
Over the last few weeks, TNX has been steadily rising, nearly reaching 4% on 2/22/23. The upshot is that financing debt-based transactions has become more expensive.
Simultaneously, XED has broken below the long standing support area of 95. Taken together, these indicators are telling us that liquidity is drying up, which explains why the stock market is starting to shudder.
What is a Liquidity Crisis?
A liquidity crisis occurs when there isn’t enough money available in the financial system for counter parties to meet their obligations. The Lehman Brothers collapse is the prototype for a liquidity crisis.
When one or more investors are unable to pay other investors to close a deal or even to make periodic payments on debt, the parties which are not being paid may run out of money to pay their own counter parties. The more this happens, the more liquidity dries up.
Eventually the system freezes and stock prices start to fall as investors sell liquid assets such as Treasury bonds and blue-chip stocks to raise money both in fear as well as a source of funds to fulfill their obligations to counter parties in the future.
What Happened on Valentine’s Day 2023?
All of which brings me to February 14, 2023 when the Eurodollar Index fell precipitously closing below 95 for the first time in several weeks. Meanwhile, the U.S. Ten Year note yield accelerated its recent climb moving above 3.8%.
Those two simultaneous events suggest that a large seller of U.S. Treasury bonds is active. In the current climate, it could be just about anyone who is doing the selling. But here are some plausible candidates:
- The Federal Reserve;
- China; or
- A financial entity that is suddenly having problems with its liquidity and has to raise capital rapidly.
None of those candidates inspires any positive thoughts.
If it’s the Federal Reserve, then it’s likely that the central bank is now aggressively increasing its QT by actively draining money from the system. A review of the Fed’s recent action on this front, however, suggests that the Fed is only removing $150 million of reserve per month, which is a miniscule amount when taking the size of the financial system into consideration.
On the other hand, if it’s Russia, China, or a combination of both it would suggest that the war in Ukraine is now moving to a more dangerous phase as these two countries are economically targeting the U.S. via the sale of the latter’s Treasury bonds.
Finally, if it’s a financial entity that is having trouble paying its bills, it will eventually become public knowledge and the dominoes may start to roll as they did with Lehman. There are known liquidity issues in commercial real estate, as I pointed out in the post highlighted above.
Stocks Test Key Support
Where it all comes together is in the stock market, where my favorite bellwether indicators, the New York Stock Exchange Advance Decline line (NYAD), the CBOE Volatility Index (VIX), the Eurodollar Index (VIX), and the Relative Strength Indicator (RSI) are flashing cautionary signals.
Note the following:
- NYAD has fallen below its 20-day moving average. That’s a short-term sell signal;
- VIX has begun to climb, a sign that bears are betting on lower prices ahead;
- XED has broken below 95 and;
- RSI is testing its neutral point of 50.
Taken together, these indicators suggest that if selling does not slow meaningfully at the current levels, the liquidity squeeze is not temporary.
The Game has Changed
Where the stock market bottom of October 2022 was at least partially fueled by a moderate improvement in liquidity, in the current market there seem to be fewer funds available to trade stocks.
Consequently, stock prices are suddenly falling.
It’s uncertain as to what’s behind the sudden change in liquidity conditions. Certainly, there could be a geopolitical angle involving Russia, China, and perhaps other players whose sole goal is to target the U.S. economy.
It is just as likely that there is a big hedge fund, real estate investment trust, or private equity company which is getting squeezed by higher interest rates and is unable to pay its bills without selling off its Treasury bond holdings.
Maybe it’s a combination of those factors or something that has yet to be revealed.
The market’s liquidity is getting squeezed. Liquidity is the market’s lifeblood, and history shows that when it gets reduced, stocks fall. If current support levels don’t hold, stocks are likely to head lower.
Editor’s Note: Despite the risks described in the article above, you can still crush the broader market. That’s where our colleague Dr. Joe Duarte comes in.
Dr. Duarte has been a professional investor and independent analyst since 1990. He is a former registered investment advisor and author of the bestselling Options Trading for Dummies, and several other books including Market Timing for Dummies and Successful Biotech Investing.
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