Tag Archives: liquidity


RIA Advisors is proud to present the 2020 Investment Summit 

Hosted By: Lance Roberts, CIO RIA Advisors


  • Michael Lebowitz, CFA – RIA Portfolio Manager
  • Teddy Valle – Pervalle Global
  • Thomas Thornton – HedgeFund Telemetry
  • Jeffery Marcus – TP Analytics

Topics include:

  • Impact of Government bailouts
  • The Fed is fighting a losing battle
  • Market Outlook
  • ETF Liquidity issues
  • And more….


Surging Repo Rates- Why Should I Care?

A subscriber emailed us regarding our repurchase agreement (repo) analysis from Tuesday’s Daily Commentary. Her question is, “why should I care about a surge in repo rates?” The commentary she refers to is at the end of this article.

Before answering her question, it is worth emphasizing that it is rare for overnight Fed Funds or Repo rates to spike, as happened this week, other than at quarter and year ends when bank balance sheets have little flexibility. Clearly, balance sheet constraints due to the end of a quarter or year are not causing the current situation.  Some say the current situation may be due to a lack of bank reserves which are used to make loans, but banks have almost $2 trillion in excess cash reserves. Although there may likely be an explanation related to general bank liquidity, there is also a chance the surge in funding costs is due to a credit or geopolitical event with a bank or other entity that has yet to be disclosed to the public.

Before moving ahead, let us take a moment to clarify our definitional terms.

Fed Funds are daily overnight loans between banks that are unsecured, or not collateralized. Overnight Repo funding are also daily overnight loans but unlike Fed Funds, are backed with assets, typically U.S. Treasuries or mortgage-backed securities. The Federal Reserve has the authority to conduct financing transactions to add or subtract liquidity to ensure overnight markets trade close to the Fed Funds target. These transactions are referred to as open market operations which involve the buying or selling of Treasury bonds to increase or decrease the amount of reserves (money) in the system. Reserves regulate how much money a bank can lend. When reserves are limited, short-term interest rates among and between banks rise and conversely when reserves are abundant, funding costs fall. QE, for instance, boosted reserves by nearly $3.5 trillion which enabled banks to provide liquidity to markets and make loans at low interest rates.

Our financial system and economy are highly leveraged. Currently, in the U.S., there is over $60 trillion in debt versus a monetary base of $3.3 trillion. Further, there is at least another $10-15 trillion of dollar-based debt owed outside of the U.S. 

Banks frequently have daily liquidity shortfalls or overages as they facilitate the massive amount of cash moving through the banking system. To balance their books daily, they borrow from or lend to other banks in the overnight markets to satisfy these daily imbalances. When there is more demand than supply or vice versa for overnight funds, the Fed intervenes to ensure that the overnight markets trade at, or close to, the current Fed Funds rate.

If overnight funding remains volatile and costly, banks will increase the amount of cash on hand (liquidity) to avoid higher daily costs. To facilitate more short term cash on their books, funds must be conjured by liquidating other assets they hold. The easiest assets to sell are those in the financial markets such as U.S. Treasuries, investment-grade corporate bonds, stocks, currencies, and commodities.  We may be seeing this already. To wit the following is from Bloomberg:  

“What started out as a funding shortage in a key U.S. money market is now making it more costly to get hold of dollars globally. After a sudden surge in the overnight rate on Treasury repurchase agreements, demand for the dollar is showing up in swap rates from euros, pounds, yen and even Australia’s currency. As an example, the cost to borrow dollars for one week in FX markets while lending euros almost doubled.”

A day or two of unruly behavior in the overnight markets is not likely to meaningfully affect banks’ behaviors. However, if the banks think this will continue, they will take more aggressive actions to bolster their liquidity.

To directly answer our reader’s question and reiterating an important point made, if banks bolster liquidity, the financial markets will probably be the first place from which banks draw funds. In turn, this means that banks and their counterparties will be forced to reduce leverage used in the financial markets. Stocks, bonds, currencies, and commodities are all highly leveraged by banks and their clientele. As such, all of these markets are susceptible to selling pressure if this occurs.

We leave you with a couple of thoughts-

  • If the repo rate is 3-4% above the Fed Funds rate, the borrower must either not be a bank or one that is seriously distressed. As such, is this repo event related to a hedge fund, bank or other entity that blew up when oil surged over 10% on Monday? Could it be a geopolitical related issue given events in the Middle East? 
  • The common explanation seems to blame the massive funding outlays due to the combination of Treasury debt funding and corporate tax remittances. While plausible, these cash flow were easy to predict and plan for weeks in advance. This does not seem like a valid excuse.

In case you missed it, here is Tuesday’s RIA repo commentary:  Yesterday afternoon, overnight borrowing costs for banks surged to 7%, well above the 2.25% Fed Funds rate. Typically the rate stays within 5-10 basis points of the Fed Funds rate. Larger variations are usually reserved for quarter and year ends when banks face balance sheet constraints. It is believed the settlement of new issue Treasury securities and the corporate tax date caused a funding shortage for banks. If that is the case, the situation should clear up in a day or two. Regardless of the cause, the condition points to a lack of liquidity in the banking sector. We will follow the situation closely as it may impact markets if it continues.

Yes, We Are In Another Tech Bubble

Technology has touched our lives in so many ways, and especially so for investors. Not only has technology provided ever-better tools by which to research and monitor investments, but tech stocks have also provided outsized opportunities to grow portfolios. It’s no wonder that so many investors develop a strong affinity for tech.

Just as glorious as tech can be on the way up, however, it can be absolutely crushing on the way down. Now that tech stocks have become such large positions in major US stock indexes as well as in many individual portfolios, it is especially important to consider what lies ahead. Does tech still have room to run or has it turned down? What should you do with tech?

For starters, recent earnings reports indicate that something has changed that deserves attention. Bellwethers such as Amazon, Alphabet and Apple all beat earnings estimates by a wide margin. All reported strong revenue growth. And yet all three stocks fell in the high single digits after they reported. At minimum, it has become clear that technology stocks no longer provide an uninterrupted ride up.

These are the kinds of earnings reports that can leave investors befuddled as to what is driving the stocks. Michael MacKenzie gave his take in the Financial Times late in October [here]:

“The latest fright came from US technology giants Amazon and Alphabet after their revenue misses last week. Both are highly successful companies but the immediate market reaction to their results suggested how wary investors are of any sign that their growth trajectories might be flattening.”

Flattening growth trajectories may not seem like such a big deal, but they do provide a peak into the often-tenuous association between perception and reality for technology. Indeed, this relationship has puzzled economists as much as investors. A famous example arose out of the environment of slowing productivity growth in the 1970s and 1980s [here] which happened despite the rapid development of information technology at the time. The seeming paradox prompted economist Robert Solow to quip [here],

You can see the computer age everywhere but in the productivity statistics.”

The computer age eventually did show up in the productivity statistics, but it took a protracted and circuitous route there. The technologist and futurist, Roy Amara, captured the essence of that route with a fairly simple statement [here]:

“We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run.” Although that assertion seems innocuous enough, it has powerful implications. Science writer Matt Ridley [here] went so far as to call it the “only one really clever thing” that stands out among “a great many foolish things that have been said about the future.”

Gartner elaborated on the concept by describing what they called “the hype cycle” (shown below).

The cycle is “characterized by the ‘peak of inflated expectations’ followed by the ‘trough of disillusionment’.” It shows how the effects of technology get overestimated in the short run because of inflated expectations and underestimated in the long run because of disillusionment.

Amara’s law/ the hype cycle

Source: Wikipedia [here]

Ridley provides a useful depiction of the cycle:

“Along comes an invention or a discovery and soon we are wildly excited about the imminent possibilities that it opens up for flying to the stars or tuning our children’s piano-playing genes. Then, about ten years go by and nothing much seems to happen. Soon the “whatever happened to …” cynics are starting to say the whole thing was hype and we’ve been duped. Which turns out to be just the inflexion point when the technology turns ubiquitous and disruptive.”

Amara’s law describes the dotcom boom and bust of the late 1990s and early 2000s to a tee. It all started with user-friendly web browsers and growing internet access that showed great promise. That promise lent itself to progressively greater expectations which led to progressively greater speculation. When things turned down in early 2000, however, it was a long way down with many companies such as the e-tailer Pets.com and the communications company Worldcom actually going under. When it was all said and done, the internet did prove to be a massively disruptive force, but not without a lot of busted stocks along the way.

How do expectations routinely become so inflated? Part of the answer is that we have a natural tendency to adhere to simple stories rather than do the hard work of analyzing situations. Time constraints often exacerbate this tendency. But part of the answer is also that many management teams are essentially tasked with the effort of inflating expectations. A recent Harvard Business Review article [here] (h/t Grants Interest Rate Observer, November 2, 2018) provides revealing insights from interviews with CFOs and senior investment banking analysts of leading technology companies.

For example, one of the key insights is that “Financial capital is assumed to be virtually unlimited.” While this defies finance and economics theory and probably sounds ludicrous to most any industrial company executive, it passes as conventional wisdom for tech companies. For the last several years anyway, it has also largely proven to be true for both public tech-oriented companies like Netflix and Tesla as well as private companies like Uber and WeWork.

According to the findings, tech executives,

“…believe that they can always raise financial capital to meet their funding shortfall or use company stock or options to pay for acquisitions and employee wages.”

An important implication of this capital availability is,

“The CEO’s principal aim therefore is not necessarily to judiciously allocate financial capital but to allocate precious scientific and human resources to the most promising projects …”

Another key insight is, “Risk is now considered a feature, not a bug.” Again, this defies academic theory and empirical evidence for most industrial company managers. Tech executives, however, prefer to, “chase risky projects that have lottery-like payoffs. An idea with uncertain prospects but with at least some conceivable chance of reaching a billion dollars in revenue is considered far more valuable than a project with net present value of few hundred million dollars but no chance of massive upside.”

Finally, because technology stocks provide a significant valuation challenge, many tech CFOs view it as an excuse to abdicate responsibility for providing useful financial information. “[C]ompanies see little value in disclosing the details of their current and planned projects in their financial disclosures.” Worse, “accounting is no longer considered a value-added function.” One CFO went so far as to note “that the CPA certification is considered a disqualification for a top finance position [in their company].”

While some of this way of thinking seems to be endemic to the tech industry, there is also evidence that an environment of persistently low rates is a contributing factor. As the FT mentions [here], “When money is constantly cheap and available everything seems straightforward. Markets go up whatever happens, leaving investors free to tell any story they like about why. It is easy to believe that tech companies with profits in the low millions are worth many billions.”

John Hussman also describes the impact of low rates [here]:

“The heart of the matter, and the key to navigating this brave new world of extraordinary monetary and fiscal interventions, is to recognize that while 1) valuations still inform us about long-term and full-cycle market prospects, and; 2) market internals still inform us about the inclination of investors toward speculation or risk-aversion, the fact is that; 3) we can no longer rely on well-defined limits to speculation, as we could in previous market cycles across history.”

In other words, low rates unleash natural limits to speculation and pave the way for inflated expectations to become even more so. This means that the hype cycle gets amplified, but it also means that the cycle gets extended. After all, for as long as executives do not care about “judiciously allocating capital”, it takes longer for technology to sustainably find its place in the real economy. This may help explain why the profusion of technology the last several years has also coincided with declining productivity growth.

One important implication of Amara’s law is that there are two distinctly different ways to make money in tech stocks. One is to identify promising technology ideas or stocks or platforms relatively early on and to ride the wave of ever-inflating expectations. This is a high risk but high reward proposition.

Another way is to apply a traditional value approach that seeks to buy securities at a low enough price relative to intrinsic value to ensure a margin of safety. This can be done when disillusionment with the technology or the stock is so great as to overshoot realistic expectations on the downside.

Applying value investing to tech stocks comes with its own hazards, however. For one, several factors can obscure sustainable levels of demand for new technologies. Most technologies are ultimately also affected by cyclical forces, incentives to inflate expectations can promote unsustainable activity such as vendor financing, and debt can be used to boost revenue growth through acquisitions.

Further, once a tech stock turns decidedly down, the corporate culture can change substantially. The company can lose its cachet with its most valuable resource — its employees. Some may become disillusioned and even embarrassed to be associated with the company. When the stock stops going up, the wealth creation machine of employee stock options also turns off. Those who have already made their fortunes no longer have a good reason to hang around and often set off on their own. It can be a long way down to the bottom.

As a result, many investors opt for riding the wave of ever-inflating expectations. The key to succeeding with this approach is to identify, at least approximately, the inflection point between peak inflated expectations and the transition to disillusionment.

Rusty Guinn from Second Foundation Partners provides an excellent case study of this process with the example of Tesla Motors [here]. From late 2016 through May 2017 the narrative surrounding Tesla was all about growth and other issues were perceived as being in service to that goal. Guinn captures the essence of the narrative:

“We need capital, but we need it to launch our exciting new product, to grow our factory production, to expand into exciting Semi and Solar brands.” In this narrative, “there were threats, but always on the periphery.”

Guinn also shows how the narrative evolved, however, by describing a phase that he calls “Transitioning Tesla”. Guinn notes how the stories about Tesla started changing in the summer of 2017:

“But gone was the center of gravity around management guidance and growth capital. In its place, the cluster of topics permeating most stories about Tesla was now about vehicle deliveries.”

This meant the narrative shifted to something like, “The Model 3 launch is exciting AND the performance of these cars is amazing, BUT Tesla is having delivery problems AND can they actually make them AND what does Wall Street think about all this?” As Guinn describes, “The narrative was still positive, but it was no longer stable.” More importantly, he warns, “This is what it looks like when the narrative breaks.”

The third phase of Tesla’s narrative, “Broken Tesla”, started around August 2017 and has continued through to the present. Guinn describes,

“The growing concern about production and vehicle deliveries entered the nucleus of the narrative about Tesla Motors in late summer 2017 and propagated. The stories about production shortfalls now began to mention canceled reservations. The efforts to increase production also resulted in some quality control issues and employee complaints, all of which started to make their way into those same articles.”

Finally, Guinn concludes, “Once that happened, a new narrative formed: Tesla is a visionary company, sure, but one that doesn’t seem to have any idea how to (1) make cars, (2) sell cars or (3) run a real company that can make money doing either.” Once this happens, there is very little to inhibit the downward path of disillusionment.

Taken together, these analyses can be used by investors and advisors alike to help make difficult decisions about tech positions. Several parts of the market depend on the fragile foundations of growth narratives including many of the largest tech companies, over one-third of Russell 2000 index constituents that don’t make money, and some of the most over-hyped technologies such as artificial intelligence and cryptocurrencies.

One common mistake that should be avoided is to react to changing conditions by modifying the investment thesis. For example, a stock that has been owned for its growth potential starts slowing down. Rather than recognizing the evidence as potentially indicative of a critical inflection point, investors often react by rationalizing in order to avoid selling. Growth is still good. The technology is disruptive. It’s a great company. All these things may be true, but it won’t matter. Growth is about narrative and not numbers. If the narrative is broken and you don’t sell, you can lose a lot of money. Don’t get distracted.

In addition, it is important to recognize that any company-specific considerations will also be exacerbated by an elemental change in the overall investment landscape. As the FT also noted, “But this month [October] can be recognised as the point at which the market shifts from being driven by liquidity to being driven by fundamentals.” This turning point has significant implications for the hype cycle: “Turn off the liquidity taps at the world’s central banks and so does the ability of the market to believe seven impossible things before breakfast.”

Yet another important challenge in dealing with tech stocks that have appreciated substantially is dealing with the tax consequences. Huge gains can mean huge tax bills. In the effort to avoid a potentially complicated and painful tax situation, it is all-too-easy to forego the sale of stocks that have run the course of inflated expectations.

As Eric Cinnamond highlights [here], this is just as big of a problem for fiduciaries as for individuals:

“The recent market decline is putting a growing number of portfolio managers in a difficult situation. The further the market falls, the greater the pressure on managers to avoid sending clients a tax bill.”

Don’t let tax considerations supersede investment decisions.

So how do the original examples of Amazon, Alphabet and Apple fit into this? What, if anything, should investors infer from their quarterly earnings and the subsequent market reactions?

There are good reasons to be cautious. For one, all the above considerations apply. Further, growth has been an important part of the narrative of each of these companies and any transition to lower growth does fundamentally affect the investment thesis. In addition, successful companies bear the burden of ever-increasing hurdles to growth as John Hussman describes [here]:

“But as companies become dominant players in mature sectors, their growth slows enormously.”

“Specifically,” he elaborates, “growth rates are always a declining function of market penetration.” Finally, he warns,

“Investors should, but rarely do, anticipate the enormous growth deceleration that occurs once tiny companies in emerging industries become behemoths in mature industries.”

For the big tech stocks, wobbles from the earnings reports look like important warning signs.

In sum, tech stocks create unique opportunities and risks for investors. Due to the prominent role of inflated expectations in so many technology investments, however, tech also poses special challenges for long term investors. Whether exposure exists in the form of individual stocks or by way of major indexes, it is important to know that many technology stocks are run more like lottery tickets than as a sustainable streams of cash flows. Risk may be perceived as a feature by some tech CFOs, but it is a bug for long term investment portfolios.

Finally, tech presents such an interesting analytical challenge because the hype cycle can cause perceptions to deviate substantially from the reality of development, adoption and diffusion. Ridley describes a useful general approach: “The only sensible course is to be wary of the initial hype but wary too of the later scepticism.” Long term investors won’t mind a winding road but they need to make sure it can get them to where they are going.

Give Me An “L” For Liquidity

After a rocky first quarter markets posted a solid second quarter and improved steadily through the third quarter. The US economy is currently rolling along at a pretty healthy pace as GDP grew at 4.2% in the second quarter and earnings have been strong. Unemployment clocked in at 3.7% for September which is incredibly low by historical standards. Indications of inflation are starting to creep into wages, materials, and transportation and many manufacturers have been able to offset them by raising prices. Through the lens of economics, investors are in good shape.

It wasn’t that long ago, however, that investors looked past a feeble economic recovery and took cheer in the large volumes of liquidity major central banks around the world infused to support financial assets. Now the time has come to reverse course. As the Economist states [here] in no uncertain terms,

“Central banks are pitiless executioners of long-lived booms and monetary policy has shifted.”

Investors who view these conditions exclusively through the lens of economics risk misreading this pivotal event: global liquidity is falling and will bring asset prices down with it.

Liquidity is one of those finance topics that often gets bandied about but it is often not well understood. It seems innocuous enough but it is critical to a functioning economy. In short, it basically boils down to cash. When there is more cash floating around in an economic system, it is easier to buy things. Conversely, when there is less, it is harder to buy things.

Chris Cole from Artemis Capital Management has his own views as to why investors often overlook liquidity [here]. He draws an analogy between fish and investors. Because fish live in water, they don’t even notice it. Because investors have been living in a sea of liquidity, they don’t even notice it. As he notes,

“The last decade we’ve seen central banks supply liquidity, providing an artificial bid underneath markets.”

Another aspect of liquidity that can cause it to be under appreciated is that it is qualitatively different at scale. A drop of water may be annoying, but it rarely causes harm. A tsunami is life-threatening. Conversely, a brief delay in getting a drink of water may leave one slightly parched, but an extended stay in the desert can also be life-threatening. We have a tendency to take water (and liquidity) for granted until confronted with extreme conditions.

One person who does not take liquidity for granted is Stanley Druckenmiller. In an overview of his uniquely successful approach to investing on Realvision [here], he describes,

“But everything for me has never been about earnings. It’s never been about politics. It’s always about liquidity.”

Not earnings or politics, but liquidity. 

While not yet extreme, the liquidity environment is changing noticeably. Druckenmiller notes,

“we’ll [the Fed will] be shrinking our balance sheet $50 billion a month,” and, “at the same time, the ECB will stop buying bonds.”

Cole describes the same phenomenon in his terms,

“Now water is being drained from the pond as the Fed, ECB, and Bank of Japan shrink their balance sheets and raise interest rates.” 

Michael Howell of CrossBorder Capital, a research firm focusing on global money flows, summarizes the situation in a Realvision interview [here]:

“In terms of global liquidity, it’s currently falling at the fastest rate that we’ve seen since 2008 …”

For some investors, the decrease in liquidity is setting off alarms. Druckenmiller points out,

“It’s going to be the shrinkage of liquidity that triggers this thing.” He goes on, “And my assumption is one of these hikes- I don’t know which one- is going to trigger this thing. And I am on triple red alert because we’re not only in the time frame, we’re in the part …” He continues, “There’s no more euro ECB money spilling over into the US equity market at the end of the year …”

Or, as Zerohedge reported [here],

“We have previously discussed the market’s mounting technical and structural problems – we believe these are a direct result of the increasingly hostile monetary backdrop (i.e., there is no longer enough excess liquidity to keep all the plates in the air).”

As the Economist notes,

“Shifts in America’s monetary stance echo around global markets,” and there is certainly evidence this is happening. Cole notes, “The first signs of stress from quantitative tightening are now emerging in credit, international equity, and currency markets. Financial and sovereign credits are weakening and global cross asset correlations are increasing.” 

Howell also chimes in, 

“You’re also seeing emerging markets central banks being forced to tighten because of the upward shock to the US  dollar.” He concludes, “Emerging market currencies are very fragile. And emerging markets stock markets are falling out of bed. These are all classic symptoms of a tightening liquidity environment.”

The governor of the Reserve Bank of India, Urjit Patel, highlighted these issues when he wrote that “Emerging markets face a dollar double whammy” in the Financial Times [here]. He describes, “The upheaval stems from the coincidence of two significant events: the Fed’s long-awaited moves to trim its balance sheet and a substantial increase in issuing US Treasuries to pay for tax cuts.” He claims that if the Fed does not recalibrate the shrinkage of its balance sheet, “Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.”

Although there is evidence that liquidity is tightening, it has not done so uniformly yet. The Economist describes,

“The integration of the global financial system has turned national financial systems into a vast single sea of money that rises and falls with changes in saving and investment around the world.”

As a result, there are a lot of crosscurrents that confound simple analysis.

For example, Zerohedge reports [here],

“When ‘QT’ [quantitative tightening] started in September of 2017, outstanding Fed credit initially kept growing well into 2018, largely because reverse repos with US banks ran off faster than securities held by the Fed decreased …” The story continues, “The markets evidently never ‘missed’ the liquidity tied up in these reverse repos, not least because high quality treasury collateral serves as a kind of secondary medium of exchange in repo markets, where it supports all kinds of other transactions.” 

Flows of capital into US markets have also temporarily concealed tighter conditions. Howell highlights “the huge amounts of money of flight capital that have come into the US over the last four years” and quantifies it as “something like $4 trillion.”

But the turning tides of liquidity that have been so noticeable abroad are now also starting to wash up on US shores, as John Dizard demonstrates in the FT [here]. When rates are higher in the US, foreign investors can buy US Treasuries and hedge out the currency risk. He notes, “This made it possible for non-US institutions to hold large bond positions that paid a positive rate of interest without incurring foreign exchange risk.” However, by the end of September, “the interbank market’s cross-currency ‘basis swap’ for euros to US dollars rose by 30 basis points and the cost of yen-dollar basis swaps went up by 46 bp.” Dizard summarizes the likely consequences:

“That was the end of foreigners paying for the US economic expansion. It also probably marked the end of the housing recovery.”

Additional factors further muddy the mix. Repatriation flows have disguised the decline in liquidity but will only do so temporarily. Further, China has historically been a large buyer of US assets., but that is changing too. As Howell notes, “China has shown no appetite for buying further US dollar assets over the last 18 months.” He concludes,

“We think they’ve now stopped. And they’re redeploying their foreign exchange reserves into Central Asia in terms of real infrastructure spending.”

Bill Blain points to yet another factor in his analysis of liquidity in Zerohedge [here]. He notes,

“What’s happened since Lehman’s demise has been a massive transfer of risk from the banking sector – which means, so the regulators tell us, that banks are now safer. Marvellous [sic]. Where did that risk go? Into the non-bank financial sector.”

Almost as if on cue, the FT reported on liquidity issues at a shadow bank in India [here]: “The banks’ woes have meant India has come to rely for credit growth increasingly on its shadow banking sector. Non-bank lenders accounted for 40 per cent of loan growth in the past year, according to Nomura, funding their expansion by relying heavily on the short-term debt market.”

This case serves as a useful warning signal for investors because it is reflective of the global expansion of shadow banking and because it demonstrates the kind of pro-cyclical and mismatched funding that caused so many problems during the financial crisis.

In sum, although various transient factors have created some noise, the overall signal is fairly clear. Zerohedge reports [here],

“With net Fed credit actually decreasing, an important threshold has been crossed. The effect on excess liquidity is more pronounced, which definitely poses a big risk for overextended financial markets.”

Whether or not the big risk is immediate or not is open for some interpretation. As Druckenmiller puts it, “we’re kind of at that stage of the cycle where bombs are going off,” which suggests the time is now. However, he implicitly suggests developed market investors still have some time when he says,

“And until the bombs go off in the developed markets, you would think the tightening will continue.”

Problems for developed markets are on the way though, as liquidity is likely to get a lot worse. Cole says,

“Expect a crisis to occur between 2019 and 2021 when a drought caused by dust storms of debt refinancing, quantitative tightening, and poor demographics causes liquidity to evaporate.” He also warns, “[Y]ou should be VERY worried about how the bigger implicit short volatility trade affects liquidity in the overall market… THAT is the systemic risk.”

If it is still hard to imagine how a subtle and abstract thing like liquidity could overwhelm demonstrably strong economic results, perhaps a lesson from history can provide a useful illustration.

In Ken Burns’ Vietnam War documentary, Donald Gregg from the CIA captures the strategic perspective of the war:

“We should have seen it as the end of the colonial era in southeast Asia, which it really was. But instead we saw it in Cold War terms and we saw it as a — a defeat for the free world — that was related to the rise of China — and it was a total misreading of a pivotal event — which cost us very dearly.” 

In other words, the subtle and abstract force of independence from colonial rule ultimately proved to be an incredibly powerful one in Vietnam. Many people wanted to believe something else and that led to very costly decisions.

Liquidity is playing the same role for investors today and investors who believe otherwise are also likely to suffer. The important lesson is that long-term investors don’t need to worry about getting all the day-to-day cross-currents just right. But they do need to appreciate the gravity of declining liquidity.

A recent story in P&I [here] articulated the challenge well: 

“Investors also must be more aware. Few recognize when conditions that could lead to a crisis are brewing, and those who do often misjudge the timing and fail to act to protect themselves and their clients from the full impact of the storm.” More specifically, “The best laid plans for protecting investment gains, and even the corpus of a portfolio, could fail if attention is not paid to the likely shortage of liquidity” 

This isn’t to say it will be easy to do or that the message will be uniformly broadcast. For example, after the significant market losses in the second week of October, the FT reports [here] that Vanguard notified clients via a tweet:

“You know the drill. In face of market volatility, keep calm and stay the course.”

“Keeping calm” is certainly good advice; it is even harder to make good decisions when one is wildly emotional and/or impulsive. However, “staying the course” makes some dubious assumptions. 

If a market decline is just a random bout of volatility then it doesn’t make sense to change course. But when liquidity is declining and Druckenmiller sees “bombs going off” and Cole expects “a crisis to occur between 2019 and 2021,” a market decline has very different information content.  

Staying the course would also make sense if your exposure to stocks is low and your investment horizon is very long, but the numbers say just the opposite. As Zerohedge reports [here],

“Outside of the 2000 dotcom bubble, U.S. households have never had more of their assets invested in the stock market.”

Further, as Gallup documents [here], the 65 and older demographic, the one presumably with the shortest investment horizon, has actually slightly increased their stock holdings. As Bill Blain comments,

“You’ve got a whole market of buy-side investors who think liquidity and government largesse is unlimited.” 

Investors reluctant to heed the warnings on liquidity can consider one more argument — which comes from Druckenmiller’s own actions. As he puts it,

“I also have bear-itis, because I made– my highest absolute returns were all in bear markets. I think my average return in bear markets was well over 50%.”

Based on what he is seeing now, he is ready to pounce:

“I … kind of had this scenario that the first half would be fine, but then by July, August, you’d start to discount the shrinking of the balance sheet. I just didn’t see how that rate of change would not be a challenge for equities … and that’s because margins are at an all time record. We’re at the top of the valuation on any measures you look, except against interest rates …”

So, investors inclined to dismiss concerns about liquidity and who would be hurt if stocks should go down a lot, should know that on the other side is Stanley Druckenmiller, with an itchy trigger finger, ready to put his money where his mouth is.

Wrapping up, it is difficult to capture just how fundamentally important liquidity is to investing, but Chris Cole probably does it as well as anyone: 

“When you are a fish swimming in a pond with less and less water, you had best pay attention to the currents.”

So let’s hear it for liquidity: It is a powerful force that can boost portfolios and one that can diminish them just as easily. 

The Weaponization of the Dollar

The Uncivil Civil War discussed the sanguine approach many investors take towards equity risk despite clear signs of domestic political turbulence. The article put the upcoming elections and the growing political divisions amongst the populace into context with market risks.

While we read plenty of politically related articles and many more investment related articles, we have found precious few that bridge the gap and gauge the effect politics has on markets. The intersection of markets and politics is important and should be followed closely, especially with a mid-term election months away. As so eloquently described by the late Charles Krauthammer, “You can have the most advanced and efflorescent cultures. Get your politics wrong, however, and everything stands to be swept away. This is not ancient history. This is Germany 1933.

In this article, we readdress politics and markets from an international perspective. In particular, we focus on suspicions we have regarding Donald Trump’s negotiation tactics and goals for the U.S. relationship with Turkey.

Emerging Markets and the Dollar

China, Turkey, and Iran are all classified as emerging markets. While the classification is broad and includes a diverse group of countries, these countries have many things in common. One is that their currencies, for the most part, are not liquid or highly valued. Thus, they heavily rely on the world’s reserve currency, the U.S. dollar, to conduct international trade.

As an example, when Pakistan buys oil from Qatar, they transact in U.S. dollars, not rupees or riyals. To facilitate trade efficiently, these countries must hold excess dollars in reserve. In almost all cases, emerging market nations rely on U.S. dollar-denominated debt for their transactional needs.

Dollar-denominated debt is currently the cause of much economic pain for Turkey. To understand why, we present a simplified example. Suppose on January 1, 2018, a Turkish corporation borrowed $100 million U.S. dollars with an agreement to pay it back with interest of 5% on August 15th, 2018. The company, as is typical, converts the loaned dollars to Turkish Lira.  On August 15, 2018, the company will convert the Lira back to dollars in order to pay the principal and interest due on the loan.

The following graph charts the Turkish Lira versus the Dollar over the life of the loan.

On January 1, 2018, one U.S. Dollar was worth 3.79 Lira. Over the next eight months, the U.S dollar appreciated significantly versus the Lira such that one U.S. dollar was worth approximately 5.81 Lira. As such, the company will now need 5.81 Lira to purchase each dollar it needs to repay the loan. Due to the strengthening of the U.S. dollar versus the Lira over the time period of the outstanding loan, the company would need 584,282,000 Lira to pay back what was originally a 378,750,000 Lira loan. In other words, the true all-in cost of borrowing was not 5% but 54%.

Turkey’s public and private sector dollar denominated loans outstanding are currently estimated to be around $500 billion. Turkish borrowers must grapple with repaying outstanding dollar-denominated loans by using more Lira to acquire the necessary dollars, and with the fact that interest rates, as set by Turkey’s central bank, have risen from 8% to 17.75%. To make matters even worse, the annualized rate of inflation is estimated to be over 100% in Turkey. Needless to say, dollar appreciation versus the Lira is bringing the Turkish economy to its knees.

Enter Donald Trump

Donald Trump, who authored a book entitled “The Art of the Deal,” takes great pride in his negotiating skills. Readers of this book know he highly values leverage in negotiations. As the President of the United States, Trump clearly has enormous leverage to change the global landscape. In the case of trade negotiations, we have seen repeated threats of tariffs against Mexico, Canada, Europe, and China. We believe the goal is to force these countries to renegotiate prior trade treaties or remove tariffs. For Trump, the leverage is the threat, which does the heavy lifting by forcing countries to negotiate or face still retaliatory tariffs or other penalties.

We suspect that Trump may also be using dollar appreciation to force nations, especially emerging markets, to comply with his demands. If you are looking for clues, consider the following Tweet from Donald Trump (8/16/2018): “Money is pouring into our cherished DOLLAR like rarely before.” Based on his bragging it seems Trump has few qualms about the recent strength of the U.S. dollar.

Regardless of the causes of the recent ascent of the U.S. dollar versus most other currencies, there is little doubt that Trump is using the dollar as a negotiating tactic to get what he wants.

There are a few reasons that Trump would manipulate the dollar, verbally or in actuality, to bring Turkey to the negotiating table. While we have no unique insight, the following reasons should be considered:

  • Turkey opposes U.S. sanctions on Iran and vows to ignore them
  • Turkey sits at a strategically important geographic intersection surrounded by Europe and Asia through which much east-to-west international trade passes
  • If in a position to provide Turkey with a bailout, the administration can slow the growing de-dollarization trend

The bottom line is that it is likely that Trump is angling to sway Turkey towards stronger relationships with the U.S. in order to influence its relationship with China, Russia, and Iran. Keep in mind China’s One Belt One Road (OBOR) project, thought of as a new silk road, would provide increased economic competition and harm to America’s economic interests. China relies on Turkey’s participation to complete this project.  As we put the finishing touches on this article, we also learned that Turkey, Iran, and Russia are in talks to schedule a trilateral summit.

Domestic Concerns

There is a healthy debate to be had about whether or not the dollar is being used as a negotiating lever. Since we may never know the answer, we focus on the potential outcomes if it is. If the dollar does strengthen further, how might it affect economic activity and assets?

The following graph, courtesy David Rosenberg at Gluskin Sheff, shows the recent decline of many assets that are sensitive to the value of the U.S. dollar.

Of the assets above, only oil and U.S. homebuilders are having much effect on the U.S. economy or the performance of domestic investments. We think these losses will be broader-based globally and involve the US stock and bond markets if the dollar continues to appreciate. The following are potential domestic issues that could be brought about by further strengthening of the U.S. dollar:

  • Deflation
  • Worsening trade deficit, possibly prompting tougher sanctions and tariffs
  • Reduced corporate earnings
  • Contagion from a banking crisis in emerging markets spreading to domestic banks

When those and other economic headwinds become more evident, it is likely all markets will react. That reaction may move from asset class to asset class sequentially, as we are currently observing, or it may hit all assets at once in a sudden cascade of revaluation.


As we wrote this article, the U.S. stock market is showing some signs of weakness. Earnings-per-share forecasts for the S&P 500 have risen by 18% this year but the index is up only 6%. This might be an acknowledgment by investors of the international and domestic problems associated with dollar strength, or it may be something else entirely like liquidity constraints. If the market continues to stagnate as the dollar moves higher, we should turn our attention to the Administration for signs of rising concern over the value of the U.S. dollar.

If in fact they do change their stance on the “cherished DOLLAR”, we would take this as a signal that either the domestic pain of a rising dollar has reached its threshold, or Turkey is acquiescing to U.S. demands. If the dollar fails to respond to verbal or direct manipulation, then it would be clear the market has another agenda and our concerns would be much graver.

For additional context on the role of the U.S. dollar in the global economy, we recommend our prior article Triffin Warned Us.

Wicksell’s Elegant Model

“It’s unbelievable how much you don’t know about the game you’ve been playing all your life.” Mickey Mantle

The word discipline has two closely related applications. Discipline may refer to the instruction and nurturing of an individual. It can also carry the connotation of censure or punishment. The purpose of discipline, in either case, is to sustain integrity or aim toward improvement. Although difficult and often painful in the moment, discipline frequently holds long-lasting benefits. Conversely, a person or entity living without discipline is likely following a path of self-destruction.

The same holds true for an economic system. After all, economics is simply the study of the collective decision-making of individuals with regard to their resources. Where capital is involved, discipline is either applied or neglected through the mechanism of interest rates. To apply a simple analogy, in those places where water is plentiful, cheap, and readily available through pipes and faucets, it is largely taken for granted. It is used for the basic necessities of bathing and drinking but also to wash our cars and dogs. In countries where clean water is not easily accessible, it is regarded as a precious resource and decidedly not taken for granted or wasted for sub-optimal uses.

In much the same way, when capital is easily accessible and cheap, how it is used will more often be sub-optimal. If I can borrow at 2% and there appear to be many investments that will return more than that, I am less likely to put forth the same energy to find the best opportunity. Indeed, at that low cost, I may not even use borrowed money for a productive purpose but rather for a vacation or bigger house, the monetary equivalent of using water to hose off the patio. Less rigor is applied when rates are low, thus raising the likelihood of misallocating capital.

Happy Talk

In November 2010, The Washington Post published an article by then Federal Reserve (Fed) Chairman Ben Bernanke entitled What the Fed did and why: supporting the recovery and sustaining price stability. In the article, Bernanke made a case for expanding on extraordinary policies due to still high unemployment and “too low” inflation. In summary, he stated that “Easier financial conditions will promote economic growth. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

To minimize concerns about the side effects or consequences of these policies he went on, “Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated.” In his concluding comments he added, “We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.” During her tenure as Fed Chair, Janet Yellen reiterated those sentiments.

Taken in whole or in part, Bernanke’s comments then and now are both inconsistent and contradictory. Leaving the absurd counterfactuals often invoked aside, if asset purchases were in 2010 “unfamiliar as a tool of monetary policy,” then what was the basis for knowing concerns to be “overstated”? Furthermore, what might be the longer-term effects of the radical conditions under which the economy has been operating since 2009? What was the basis of policy-makers’ arguments that extraordinary policies will not breed unseen instabilities and risks? Finally, there is no argument that the Fed has “the tools to unwind these policies,” there is only the question of what the implications might be when they do.

In the same way that no society, domestic or global, has ever engaged in the kinds of extraordinary monetary policies enacted since the Great Financial Crisis (GFC), neither has any society ever tried to extract itself from them. These truths mandate that the uncertainty about the future path of the U.S. economy is far more acute than advertised.

Even though policy-makers themselves offered no evidence of having humbly and thoroughly thought through the implications of post-GFC policies, there is significant research and analysis from which we can draw to consider their implications apart from the happy talk being offered by those who bear no accountability. Looking back on the past 60+ years and observing the early stages of efforts to “unwind” extraordinary policies offers a clearer lens for assessing these questions and deriving better answers.

The Ghost of Irving Fisher

Irving Fisher is probably best known by passive observers as the economist whose ill-timed declaration that “stock prices have reached a permanently high plateau” came just weeks before the 1929 stock market crash. He remained bullish and was broke within four weeks as the Dow Jones Industrial Average fell by 50%. Likewise, his reputation suffered a similar fate.

Somewhat counter-intuitively, that experience led to one of his most important works, The Debt-Deflation Theory of Great Depressions. In that paper, Fisher argues that overly liberal credit policies encourage Americans to take on too much debt, just as he had done to invest more heavily in stocks. More importantly, however, is the point he makes regarding the relationship between debt, assets and cash flow. He suggests that if a large amount of debt is backed by assets as opposed to cash flow, then a decline in the value of those assets would initiate a deflationary spiral.

Both of those circumstances – too much debt and debt backed by assets as opposed to cash flow – certainly hold true in 2018 much as they did in 2007 and 1929. The re-emergence of this unstable environment has been nurtured by a Federal Reserve that seems to have had it mind all along.

Even though Irving Fisher was proven right in the modern-day GFC, the Fed has ever since been trying to feed the U.S. economy at no cost even though extended periods of cheap money typically carry an expensive price tag. Just because the stock market does not yet reflect negative implications does not mean that there will be no consequences. The basic economic laws of cause and effect have always supported the well-known rule that there is no such thing as a free lunch.

Cheap Money or Expensive Habit?

Interest rates are the price of money, what a lender will receive and what a borrower will pay. To measure whether the price of money is cheap or expensive on a macro level we analyze interest rates on 3-month Treasury Bills deflated by the annualized consumer price index (CPI).  Using data back to 1954, the average real rate on 3-month T-Bills is +0.855% as illustrated by the dotted line on the chart below.

When the real rate falls below 0.20%, 0.65% below the long-term average, we consider that to be far enough away from the average to be improperly low. The shaded areas on the chart denote those periods where the real 3-month T-Bill rate is 0.20% or below.

Of note, there are two significant timeframes when real rates were abnormally low. The first was from 1973 to 1980 and the second is the better part of the last 18 years. The shaded areas indicating abnormally low real interest rates will appear on the charts that follow.

The chart below highlights real GDP growth. The post-war average real growth rate of the U.S. economy has been 3.20%. Based on a seven-year moving average of real economic growth as a proxy for the structural growth rate in the economy, there are two distinct periods of precipitous decline. First from 1968 to 1983 when the 7-year average growth rate fell from 5.4% to 2.4% and then again from 2000 to 2013 when it dropped from 4.1% to 0.9%. Interestingly, and probably not coincidentally, both of these periods align with time frames when U.S. real interest rates were abnormally low.

Revisiting the words of Ben Bernanke, “Easier financial conditions will promote economic growth.” That does not appear to be what has happened in the U.S. economy since his actions to reduce real rates well below zero. Although the 7-year average growth rate has in recent years risen from the 2013 lows, it remains below any point in time since at least 1954.

Similar to GDP growth in periods of low rates, the trend in productivity, shown in the chart below, also deteriorates. This evidence suggests something contrary to the Fed’s claims.

Despite what the central bankers tell us, there is a more convincing argument that cheap money is destructive to the economy and thus the wealth of the nation. This concept no doubt will run counter to what most investors think, so it is time to enlist the work of yet another influential economist.

Wicksell’s Elegant Model

Knut Wicksell was a 19th-century Swedish economist who took an elegantly simple approach to explain the interaction of interest rates and economic cycles. His model states that there are two interest rates in an economy.

First, there is the “natural rate” which reflects the structural growth rate of the economy (which is also reflective of the growth rate of corporate earnings). The natural rate is the combined growth of the working age population and the growth in productivity. The chart of the 7-year moving average of GDP growth above serves as a reasonable proxy for the structural economic growth rate.

Second, Wicksell holds that there is the “market rate” or the cost of money in the economy as determined by supply and demand. Although it is difficult to measure these terms with precision, they are generally accurate. As John Maynard Keynes once said, “It is better to be roughly right than precisely wrong.”

According to Wicksell, when the market rate is below the natural rate, there is an incentive to borrow and reinvest in an economy at the higher natural rate. This normally leads to an economic boom until demand drives up the market rate and eventually chokes off demand. When the market rate exceeds the natural rate, borrowing slows along with economic activity eventually leading to a recession, and the market rate again falls back below the natural rate. Wicksell viewed the divergences between the natural rate and the market rate as the mechanism by which the economic cycle is determined. If a divergence between the natural rate and the market rate is abnormally sustained, it causes a severe misallocation of capital.

If the market rate rises above the natural rate of interest, then no smart businessman would be willing to borrow at 5% to invest in a project with an expected return of only 2%. Furthermore, no wise lender would approve it. In this environment, only those with projects promising higher marginal returns would receive capital. On the other hand, if market rates of interest are held abnormally below the natural rate then capital allocation decisions are not made on the basis of marginal efficiency but according to the average return on invested capital. This explains why, in those periods, more speculative assets such as stocks and real estate boom.

To further refine what Wicksell meant, consider the poor growth rate of the U.S. economy. Despite its longevity, the post-GFC expansion is the weakest recovery on record. As the charts above reflect, the market rate has been below the natural rate of the economy for most of the time since 2001. Wicksell’s theory explains that healthy, organic growth in an economy transpires when only those who are deserving of capital obtain it. In other words, those who can invest and achieve a return on capital higher than that of the natural rate have access to it. If undeserving investors gain access to capital, then those who most deserve it are crowded out. This is the misallocation of capital between those who deserve it and put it to productive uses and those who do not. The result is that the structural growth rate of the economy will decline because capital is not efficiently distributed and employed for highest and best use.

Per Wicksell, optimal policy should aim at keeping the natural rate and the market rate as closely aligned as possible to prevent misallocation. But when short-term market rates are below the natural rate, intelligent investors respond appropriately. They borrow heavily at the low rate and buy existing assets with somewhat predictable returns and shorter time horizons. Financial assets skyrocket in value while long-term, cash-flow driven investments with riskier prospects languish. The bottom line: existing assets rise in value but few new assets are added to the capital stock, which is decidedly bad for productivity and the structural growth of the economy.


As central bankers continue to espouse policies leading to market rates well-below the natural rate, then, contrary to their claims, structural economic growth will fail to accelerate and will actually continue to contract. The irony is that the experimental policies, such as those prescribed by Bernanke and Yellen, are complicit in constraining the growth the economy desperately needs. As growth languishes, central bankers are likely to keep interest rates too low which will itself lead to still lower structural growth rates. Eventually, and almost mercifully, structural growth will fall below zero. The misallocated capital in the system will lead to defaults by those who should never have been allocated capital in the first place. The magnitude and trauma of the ensuing financial crisis will be determined by the length of time it takes for the economy to finally reach that flashpoint.

As discussed in the introduction, intentionally low-interest rates as directed by the Fed is reflective of negligent monetary policy which encourages the sub-optimal use of debt. Given the longevity of this neglect, the activities of the market have developed a muscle memory response to low rates. Adjusting to a new environment, one that imposes discipline through higher rates will logically be an agonizing process. Although painful, the U.S. economy is resilient enough to recover. The bigger question is do we have Volcker-esque leadership that is willing to impose the proper discipline as opposed to continuing down a path of self-destruction? In the words of Warren Buffett, chains of habit are too light to be felt until they are too heavy to be broken.