Is the banking system’s recent liquidity crunch just the ‘Tip of the Iceberg’?
From Newsmax
So far, Wall Street seems to have been able to shrug off the impeachment issue, and the stock market seems locked in the same nervous holding pattern it’s been in since 2018. However, that could all change—considering recent uncertainties impacting the markets, which include recession fears, renewed Middle East tensions, and a partially flat yield curve.
Liquidity Mystery
Another uncertainty emerged in September that hasn’t received too much attention, but could be just as significant. The U.S. banking system experienced an overnight liquidity crunch. Suddenly, banks didn’t have enough cash on hand to meet operational needs. The increased demand for cash pushed the interest rate banks charge each other on short-term loans from their usual 2.00-2.25% range up to nearly 10%.
As a result, the Federal Reserve stepped in to inject liquidity into the banking system.
The way it works is similar to going to a pawn shop when you’re short on cash. You give the pawn shop something of value, or collateral, and the pawn shop provides you with a short-term loan based on the value of your collateral. Once you pay back the loan, you get your collateral back.
It’s similar with banks, except when they’re short on cash, they’ll sell securities, like U.S. treasuries, to the Federal Reserve or each other—with an agreement to buy them back in the future, usually the next day.
These types of transactions are known as Repurchase Agreements, or “overnight repos”, because they usually occur at night.
The first repo on September 16 pumped $53 billion into the economy, the next day $75 billion more, and the following day another $75 billion.1 What started as a two-week operation has been extended through the end of January 2020.2
What’s most unsettling is that no one has a definitive explanation for the increased demand for liquidity. In other words, where did all the cash go?
Fed Chairman Powell attributed it to massive cash withdrawals by corporations to pay their September 15th tax payments.3 However, these withdrawals occur every year, without creating a liquidity crunch. Additionally, Trump’s corporate tax cuts should have made a crunch less likely, not more.
Others blame it on revamped rules stemming from the Financial Crisis, requiring banks to keep increased cash reserves on deposit with the Federal Reserve. However, those rules have been in place for over 10 years without a liquidity crunch occurring.
I believe someone knows what caused the incident, but no one is talking about it. As an advisor, that makes me nervous, because it feels eerily familiar.
Iceberg Ahead?
Remember that in 2008, it wasn’t until it was too late that we learned how the banks had all tied themselves together with credit default swaps. Up until that point, many analysts predicted the subprime mortgage crisis might be just a bump in the road for the economy. It was like an iceberg—some danger was visible, but the extent of it remained hidden … until we crashed into it.
Could the recent liquidity crunch be early evidence that another financial crisis is brewing?
No one knows for sure. However, with it being just one of the many skeletons in the world’s economic closet, it’s important to be aware of it.
Is the Banking System’s Recent Liquidity Crunch
Just the ‘Tip of the Iceberg’?
So far, Wall Street seems to have been able to shrug off the impeachment issue, and the stock market seems locked in the same nervous holding pattern it’s been in since 2018. However, that could all change—considering recent uncertainties impacting the markets, which include recession fears, renewed Middle East tensions, and a partially flat yield curve.
Liquidity Mystery
Another uncertainty emerged in September that hasn’t received too much attention, but could be just as significant. The U.S. banking system experienced an overnight liquidity crunch. Suddenly, banks didn’t have enough cash on hand to meet operational needs. The increased demand for cash pushed the interest rate banks charge each other on short-term loans from their usual 2.00-2.25% range up to nearly 10%.
As a result, the Federal Reserve stepped in to inject liquidity into the banking system.
The way it works is similar to going to a pawn shop when you’re short on cash. You give the pawn shop something of value, or collateral, and the pawn shop provides you with a short-term loan based on the value of your collateral. Once you pay back the loan, you get your collateral back.
It’s similar with banks, except when they’re short on cash, they’ll sell securities, like U.S. treasuries, to the Federal Reserve or each other—with an agreement to buy them back in the future, usually the next day.
These types of transactions are known as Repurchase Agreements, or “overnight repos”, because they usually occur at night.
The first repo on September 16 pumped $53 billion into the economy, the next day $75 billion more, and the following day another $75 billion.1 What started as a two-week operation has been extended through the end of January 2020.2
What’s most unsettling is that no one has a definitive explanation for the increased demand for liquidity. In other words, where did all the cash go?
Fed Chairman Powell attributed it to massive cash withdrawals by corporations to pay their September 15th tax payments.3 However, these withdrawals occur every year, without creating a liquidity crunch. Additionally, Trump’s corporate tax cuts should have made a crunch less likely, not more.
Others blame it on revamped rules stemming from the Financial Crisis, requiring banks to keep increased cash reserves on deposit with the Federal Reserve. However, those rules have been in place for over 10 years without a liquidity crunch occurring.
I believe someone knows what caused the incident, but no one is talking about it. As an advisor, that makes me nervous, because it feels eerily familiar.
Iceberg Ahead?
Remember that in 2008, it wasn’t until it was too late that we learned how the banks had all tied themselves together with credit default swaps. Up until that point, many analysts predicted the subprime mortgage crisis might be just a bump in the road for the economy. It was like an iceberg—some danger was visible, but the extent of it remained hidden … until we crashed into it.
Could the recent liquidity crunch be early evidence that another financial crisis is brewing?
No one knows for sure. However, with it being just one of the many skeletons in the world’s economic closet, it’s important to be aware of it.
If you’re interested in keeping up with these types of issues that could impact your ability to prepare for retirement, visit TheRetirementIncomeStore.com to sign up for our monthly newsletter.
David J. Scranton
Host of The Income Generation Show
References:
2. https://www.nytimes.com/2019/10/11/business/economy/federal-reserve-treasury-bills.html
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