Steno's Signals: Liquidity Will Soon Be Drier than a Martini

we've moved from a scenario with benign liquidity Trends in the U.S to a scenario where the conditions now favor a higher risk of shrinking liquidity and a higher risk of shrinking growth consequently and I also find good reasons to expect that inflation will drop further in such a scenario since inflation is also linked to credit creation and money growth so with money growth down inflation should go down and growth should go down with it and therefore the macro regime indicator tells you to expect liquidity to go down inflation to go down and growths go down through May and June the signals are telling me that the liquidity Outlook is worsening welcome to this edition of Steno signals we have a tremendous for you today with new action in the banking sector in the US we will go through the details of the First Republic deal and we will look into whether other banks will suffer again this week and into next week as well the underlying momentum for liquidity is worsening now and every month we update our so-called macro regime indicator at stereo signals and this month we look into a totally different environment compared to what we were faced with in April and March so if we look at this regime model we basically divide the world into three main variables of relevance to the macro Outlook first of all the liquidity Outlook secondly the growth Outlook and certainly the inflation Outlook and currently we are faced with a scenario where we should expect liquidity to go down inflation to go down and growth to go down over the course of the next 30 days according to our forward-looking models in this edition of Steno signals we'll spend the most time on assessing the liquidity Outlook since it's the variable that has changed directions since April and March uh now we expect liquidity to dwindle over the next 30 to 60 days compared to a scenario in in March and April where we had an increasing liquidity picture uh and it obviously comes with repercussions for your portfolio when liquidity dwindles relative to a scenario where liquidity increases in the financial system so let's have a look at some of the details and I want to start with the takeaways from the deal uh that was struck between JP Morgan and the financial authorities in relation to First Republic Bank over the weekend um one of the interesting things here is that First Republic Bank used the so-called emergency lending measures from the FED Reserve to a very large extent over the course of February March and April by the end of the first quarter the First Republic Bank had a um an outstanding of roughly 80 billion in emergency lending um vis-a-vis the Federal Reserve and obviously a solution was needed to um to this emergency lending when JB Morgan decided to purchase the remainings of First Republic Bank and the interesting thing here is that JPMorgan will pay roughly 60 billion out of this now 90 billion Bill uh through the Federal Reserve over the course of the next five years they paid 10 billion up front and they pay 50 billion uh over five years they receive a loan from the FDIC of 50 billion um and uh the remainings will have to be covered by the fds FDIC either via um cash assets uh still available in First Republic Bank or via the depositor base in the FDIC so essentially the war chest of liquidity that is uh within the FDIC so the FDIC will take a loss of at least 13 billion on this deal um and they may even take a larger loss than that that is unknown at the current juncture but in any case this is another big loss for the FDIC and it comes on top of another couple of bank failures just over the past month or so right now as we speak we see Carnage in the regional banking sector in markets again today Pac West another California Bank is deeply underwater in equity space and it is currently um the Market's focus on whether this bank will be the next to suffer um in this string of events and underlying now that we have weakening liquidity Trends I find it hard to see the argument for abating risks in this Regional banking sphere um to me it looks like it will accelerate given the underlying momentum in liquid seats hi I'm ralphal the CEO and co-founder of realvision the financial world is a complicated world right now it's a really complicated macro picture and there's a lot of risks real vision and our YouTube channel help you navigate those risks so subscribe now to the channel and never miss an update there is simply too much going on so subscribe now thank you so take one step back um I'd like to look a bit at the balance sheet of First Republic Bank and why it is so important this deal that JPMorgan struck with the FDIC to purchase the remainings of the First Republic Bank if we look at a typical Bank um the depositor base is the biggest funding source um and when depositors leave the banking system or the bank first Republic in this case to a very large extent over a short time span um First Republic simply needs to replace these uh these deposits with another funding source and they took up large emergency loans at the Federal Reserve to cover for the depositor base and that is why the FDIC ultimately uh has to take a a loss now given that this emergency lending cannot be fully covered in the deal with JB organ if we look at the details of of this deal with JP Morgan um I think the so-called loss share solution between the FDIC and JPMorgan is interesting um JB Morgan basically negotiated a 80 to 20 split on potential losses on the loan book that they bought from First Republic Bank meaning that in case of a default the FDIC will take the first 80 of the loss and then the JB Morgan will take the remaining 20 um so it is a very safe deal I'd say for for JB Morgan but this is not a sign to take confidence um if JB Morgan is not willing to buy the remainings of First Republic Bank without getting an 80 to 20 split in this lost share agreement it is probably a signal that they are afraid of losses in the loan book um we know that First Republic Bank has a relatively large exposure towards commercial real estate but also um single-family housing in California and elsewhere uh in the western uh parts of of the US and the collateral underlying these loans um is is underwater given the recent developments that we've seen price wise in both commercial real estate but also now to a certain extent in um in residential uh real estate and the question is whether this is a signal to shareholders in all the regional Banks uh to run away and frankly um that is kind of the mood we get from markets right now that um this lost share deal that JB Morgan managed to negotiate is not a um something to take comfort in since it is a signal that they are scared of the quality of the loan book and it is a signal that they are scared of the underlying price development in the collateral in real estate underlying these loans and if we look at the market reaction post this JP Morgan deal uh it is very very clear that the market finds JP Morgan to be the winner and Regional Banks to be the losers um potentially also the FDIC to be the loser here JB Morgan has rallied on the back of this deal um probably speaking while um we still see this increasing gap between the price development in jpmorgan's uh Equity base relative to what we see in the regional banking space and I think this overarching theme in U.S financials will continue we should expect large caps to outperform small cap Banks as a consequence of this banking turmoil and as a consequence of the withdrawal of liquidity that we will now be faced with over the coming months so why is this deal relevant to the liquidity Outlook well since First Republic Bank um had major lines with the Federal Reserve by these emergency lending measures the Federal Reserve balance sheet also increased during March when First Republic ban used for example the discount window facility to a very large extent at some point First Republic Bank made up I think it was 70 73 of the total lending in this discount window and now that JB Morgan will pay back parts of this and the FDIC will pay back parts of this loan to the Federal Reserve as of this week we should expect the Federal Reserve balance sheet to shrink again since this emergency lending is being paid back by the FDIC and indirectly by JPMorgan the rest of the loan will be paid back in five years and that also means that we should expect decline in the amount of cash assets held by Regional Banks and it goes hand in hand with this shrinking balance sheet from the Federal Reserve now that emergency lending measures are being brought down and this ultimately means that fewer dollars will be around in the banking system um you could argue that the reason for this shrinkage is okay or decent but it is still an outright decline in the amount of dollars available to the financial system and it is something that we always remain on the watch for since liquidity if is of such relevance to asset allocation and uh positioning in in markets and this happens at the same time as the U.S treasury is now closing in on the so-called crossover date we've been talking a lot about the U.S treasury and how the U.S treasury impacts liquidity in Commercial Bank systems and currently the U.S treasury is very close to running out of ammunition we received the news yesterday that the official projected crossover date the date where U.S treasury can no longer fund the federal government operations um will now be moved to First of June maybe even late May uh this is something that I've been warning about over the past months that um tax income of the federal government was below par and that the U.S treasury was running on fumes already this also means that the U.S treasury can no longer add liquidity to any major extent from here while as soon as we get at that ceiling deal the U.S treasury also told us yesterday that they plan on issuing a truckload a bit into markets over the course of July August September meaning that they will issue debt and then hold that liquidity at the Federal Reserve um and thereby withdrawing dollar liquidity from commercial Banks and from private systems and this is obviously of relevance when it happens on top of an already shrinking Fit balance sheet due to these um technicalities around the emergency lending measures and therefore the overall picture is now that the U.S treasury is likely to start withdrawing liquidity within say three four weeks from now at the latest the regional banking stress now leads to shrinking liquidity due to the FDIC paying back parts of the emergency lending and on top of that we still have the quantitative tightening of 95 billion dollars a month running from the Federal Reserve and therefore the liquidity profile here in the dotted light blue line Looks if not outright abysmal then at least very very bad uh for the next say three four months and typically we have a pretty neat correlation between equity returns and the developments into all of liquidities or the amount of dollars available uh to private markets and um I wouldn't be surprised to see a similar development this time around that equities will start losing momentum because of this withdrawal of dollar liquidity it will also spill over to crypto uh if you show correlations hold and the interesting thing here is that uh the latest update we received from the reserve on when to expect if it Reserve to accept that liquidity is now adequate relative to the size of the economy uh is a speech given by Chris Waller a member of the fomc just a few months back and he hinted that the overall amount of dollars available to the financial system should roughly equal 10 of the gross domestic product on a running basis to be in balance and we're still in between seven and eight hundred billion from that Target meaning that the Federal Reserve will likely continue to withdraw liquidity for the time being since their rule of thumb um is that 10 of GDP is what's needed to have a financial system in Balance so let's see whether they can get all the way down to such liquidity levels I kind of doubt it but the direction of travel travel is relatively clear and the interesting thing is that when we look at liquidity globally we've had a scenario so far this year where we've seen liquidity additions from Asia we've seen liquidity additions through March and April from the US while we've seen a pretty um flatlining development in liquidity in Europe and we now also basically know that liquidity will shrink quite a lot into the end of the second quarter in Europe the reason is that the so-called targeted long-term operations of the European Central Bank will start maturing in June September December and the biggest chunk of these teal throws as they're called will mature by the end of June and on my estimates we should expect a withdrawal of right about 600 billion euros by the end of June that is roughly equivalent to the liquidity withdrawal that I expect in dollar markets so both in Euro and dollar markets we will have a substantial shrinkage of liquidity through May June and probably July as well and it comes on top of already very weak signals from various Bank lending surveys one of the reasons why I find liquidity to be of relevance is that it correlates to risk appetite it correlates to the availability of lending and it correlates to the demand for credit so when there's a decline in liquidity the availability of credit the availability of a loan also shrinks at the same time and therefore typically correlates with economic activity after a short time span as well and if we look at the most recent survey from Europe um the ECP is we published this quarterly lending survey today and as you can see here on the charts we are now back at crisis levels when it comes to the um appetite for loans we also back at crisis levels when we look at credit standards so basically banks have tightened up standards quite a lot over the past quarter and next Monday we get the similar survey out of the US and I would very similar results a lack of appetite follows and a lack of appetite from the creditors as well from the banks of giving out handing out credit and that is something that typically is built over to activity levels um because in our hyper financial aid system we need credit growth to grow it is basically as symbols as that so when we look at the European markets and I'll get back to the U.S markets in a second uh I think this shrinkage of liquidity into June risks refueling the so-called fragmentation trade in in Europe um and what I mean by the fragment trade fragmentation trade is that um peripheral Bond deals so Italy Spain Reese Portugal uh will likely suffer relative to core members of the European Union such as Germany and France and this is typically also something that spills over to a weaker Euro versus the US dollar I remain highly alert for possibilities of entering shorts in euro dollar now meaning that I'm betting on a stronger dollar which is currently not a consensus View and it relates to this risk of new fragmentation within the European Union once liquidity shrinks and once activity levels decline due to this lack of appetite for credit growth and if we look at the equity space in in Europe um I also find a pretty neat correlation between the German Dax index so the German Equity index relative to the yearly developments in European liquidity and now that we should expect liquidity to 20 roughly 1 trillion year over year in Europe into June we should probably also expect the decks to lose a bit of momentum and the conditions now start to favor a much more defensive allocation in my view I've been if not hyper bullish then at least very bullish on technology consumer discretionary crypto Etc through February March and April but I'm now starting to flip my book in a defensive Direction as a consequence of these liquidity signals but there there are a few places on Earth with relatively decent liquidity Trends still uh one of them being Japan um and a lot of people expected fireworks from the bank of Japan when they held their meeting late last week and we didn't really get that uh the can was kicked down the road uh on their decision uh to support the youth curve in Japan and they launched a one-year review of the monetary policy setup uh which was initially taken as a sign that bank of Japan would move nowhere and they'd continue to print Japanese Yen for the next year and I think that is a relatively Fair assumption and should they move the needle on their u-curve control so allowing the 10-year uh bunt yield to move higher in the Japanese uh Bond curve then you should probably also expect them to support the new level of the new cap for the 10-year bond yield with a new um on purchase program to ensure that the market understands that this is a new Gap so even in such a scenario I actually think that the bank of Japan will continue to print new Japanese Yen and we have decently similar setup in China where the People's Bank of China the Chinese Central Bank is also adding liquidity at least on a quarterly basis the momentum has faded quite substantially in April but we still see liquidity additions and not liquidity withdrawals so liquidity Trends are much more benign in the nation than they are in the west and that is something to uh remain on the watch for when you allocate your portfolio if you look at the global Trends relative to the S P 500 as the last chart before I move on to the um q a session we see kind of a flatlining trend in G6 liquidity so here I at the liquidity in China Japan Europe uh the US UK Etc um and we saw the bottom back in November last year we've seen a small rebound and then we've seen a flatline tendency but now that we should expect both dollar and Euro liquidity to dwindle um by roughly six 700 billion uh worth of euros and dollars respectively then I expect Global liquidity on aggregate to also suffer and that is typically bad news for risk Assets in the west and therefore I find this liquidity Outlook to Warrant a um a flip towards a more defensive allocation in your portfolio meaning that in equity space Healthcare to Staples utilities Etc will outperform some of the high risk sectors such as technology and and consumer discretionary likely and now that we have the reporting season mostly behind us I also think the timing could be right to to at least move parts of your portfolio in a defensive Direction which also means adding to bonds we can also see how bonds perform again today with all of the turmoils surrounding Regional Banks and now pacwest is being sold in in markets and let's see whether packwest can cope with with this sell-off on the back of the deal being struck between JB Morgan and the FDIC to um to buy the remainings of the First Republic Bank so to sum up before we move to the um q a session we've moved from a scenario with benign liquidity Trends in the U.S to a scenario where the conditions now favor a higher risk of shrinking liquidity and a higher risk of shrinking growth consequently and I also find good reasons to expect that inflation will drop further in such a scenario since inflation is also linked to credit creation and money growth so with money growth down inflation should go down and growth should go down with it and therefore the macro regime indicator tells you to expect liquidity to go down inflation to go down and growth to go down through May and June and that is if not in sharp contrast to martial April then at least a game changer from a portfolio perspective let's move on to uh the questions from the audience um we have a question from from Sam here uh in this low liquidity environment what asset allocations would you recommend um if converting to cash is not an option some Investments such as Retirement accounts cannot be converted into Cash without harsh tax penalties um I think the safest bet here is to look for Bonds in the three to five year space um in the dollar curve I also think some of the safer pets would be in in healthcare and consumer Stables utility stocks and then um it may also be of relevance to add allocations to Asia since the liquidity Trends are much more benign in the nation than than in the west right now um couldn't race comment on where we are with the Wallaroo framework that he proposed a few months ago um I I guess I briefly touched upon it during the presentation but uh the wall of rule suggests that you should have 10 of the gross the medicine stick product um in liquidity meaning that given current levels of nominal GDP we should roughly expect 2.6 trillion to be the equilibrium state for liquidity and we are currently stock above 3 trillion so um there is still a gap of in between seven and eight hundred billion to cover uh for the Federal Reserve if they want to get to that 2.6 Target um I'm personally not sure they will get there um our great founder of reservation Bible pal has a whole load of arguments why it's impossible to get there and I think he will eventually be proven right on that theory uh but short term they will try to get there um and we basically know the trajectory of liquidity in May June and it will not be pretty question from Olek uh on the debt ceiling um how do I expect it to play out well we essentially know now that time is of essence um given that the crossover date is late may maybe first week of June uh meaning that we have roughly four weeks left until the partial shut down is needed to keep the federal government afloat um currently I see no whatsoever signals that they're close to a compromise and um given what we've seen um in Congress over the past couple of months I don't hold high hopes that they will agree on anything at all until one minute to deadline meaning that we will probably end up in a scenario um in in late May early June with a lot of uncertainty around um the whole funding Outlook with a lot of uncertainty in equity space and I don't necessarily think it's a bad scenario for the US dollar since we get some of these Safe Haven flows back in such a situation so I expect this to um go down right to the wire and I expect the deal to be struck probably a few days after that line final question from Paul um uh could you elaborate on how you differ from Raul and ralphal and Michael Howell on liquidity and I think the reason why I feel so confident that we will have short-term liquidity a short-term liquidity shrinkage here is that we know the maturity dates of the loans given from the European Central Bank to European Banks they will not be replaced unless the European Central Bank finds an opportune to do so and they're currently not uh discussing that and um on top of of that I also think it is Crystal Clear what happens to follow liquidity once the debt ceiling uh is is lifted because then the U.S treasury will rebuild its more chest at the Federal Reserve and that means we're throwing liquidity from private markets uh I agree with Mike Howell and ralphal on say the six nine 12 months outlook for liquidity this is a tactical view um covering May June because we have these technicalities leading to a shrinking liquidity picture short term um and those technicalities uh will not be um covered Fall by QE not as far as I can see uh over the course of the next few months because we simply need a crisis to unfold before QE can can get back in the Limelight are we amidst the crisis yes but it's simply not severe enough for the central banks to Cave into it yeah uh time for our final question um from Gary can the U.S treasury primarily issue bills to replenish the TGA thereby mitigating the liquidity decline by running down the uh reverse repo facility this is a tremendous question from Gary and I'm actually sad that I did not address this myself the reverse repo facility um is a facility that allows mainly money market funds to park dollars in return for t-bills as collateral so if more t-bills are around then there are no reasons for the um money market funds to park the dollars at this facility at different Reserve so Gary is absolutely right if Janet Yellen decided to issue only T bills then we would have a more or less liquidity neutral replenishment of the treasury general account it wouldn't be the typical move from the U.S treasury they typically try to spread their duration risk across the curve meaning that they will both issue T bills two-year five-year 10-year Etc and a conservative institution like the U.S treasury will not decide on an opportune basis to only issue bills I can almost guarantee that so net net we will see a liquidity withdrawal but um your spot on the more bills the better um and uh from the communication we had yesterday my impression is that they will spread the issuance uh over the curve and not just leave issuance in the very very short-term bills I think I will leave it there for this week's edition of steno signals um if you want answers to your questions you can also leave a question in the comments section after watching this and I will make sure to answer as many as possible ahead of the show again next week remember that this is just a window into my methodology into my thinking I cannot guarantee you that you have the same risk appetite or the same trait Horizon as I have but what I can guarantee you is that I will watch these liquidity Trends on a weekly basis and right now I'm I'm I feel very certain that liquidity twin Trends are turning much less benign for me and June thank you very much for watching we hope you enjoyed the video at realvision we help you understand the complex world of Finance business and the global economy with in-depth analysis from real experts Join the Revolution at realvision.com

Channel: Real Vision Finance

Views: 10,696

Keywords: Finance, Markets, Economy, Stock Market, Investing, Trading, Financial Literacy, Recession, Interview, Conversation, Strategy, Insight, Analysis, Thesis, Short Seller, Real Vision, Equities, Raoul Pal, Inflation, Stagflation, Monetary Policy, Money, Federal Reserve, Fed, andreas steno, andreas steno larsen, steno signals, first republic bank, jp morgan, global liquidity, Q&A, sell in may and go away, financial markets, finance podcast, realvision, macro podcast, macroeconomics, QT, QE, interest

Id: pDiFWFr5r2U

Length: 31min 2sec (1862 seconds)

Published: Thu May 18 2023