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

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1:24And now to the top analysis of today's markets.

1:34The signals are telling me that the liquidity outlook is worsening. Welcome to this edition of StenoSignals. We have a tremendous feed for you today with new action in the banking sector in the U.S. 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 StenoSignals. And this month we look into a totally different environment compared to what we were faced with in April and March.

2:24So 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 thirdly, 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 StenoSignals, we'll spend the most time on assessing the liquidity outlook since it's the variable that has changed direction since April and March.

3:04Now we expect liquidity to dwindle over the next 30 to 60 days compared to a scenario in March and April where we had an increasing liquidity picture. 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 that was struck between JP Morgan and the financial authorities in relation to First Republic Bank over the weekend. One of the interesting things here is that First Republic Bank used the so-called emergency lending measures from the Federal Reserve to a very large extent over the course of February, March and April.

3:54By the end of the first quarter, the First Republic Bank had an outstanding of roughly$80 billion in emergency lending vis-a-vis the Federal Reserve. And obviously, a solution was needed to this emergency lending when J.P. Morgan decided to purchase the remainings of First Republic Bank. And the interesting thing here is that JP Morgan will pay roughly$60 billion out of this now$90 billion bill to the Federal Reserve over the course of the next five years. They pay$10 billion up front, and they pay$50 billion over five years. They receive a loan from the FDIC of$50 billion. And the remainings will have to be covered by the FDIC, either via cash assets still available in First Republic Bank or via the depositor base in the FDIC.

4:58So essentially the wall chest of liquidity that is within the FDIC. So the FDIC will take a loss of at least$13 billion on this deal. 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. PacWest, another Californian bank, is deeply underwater in equity space and it is currently the market's focus on whether this bank will be the next to suffer in this string of events.

5:46And underlying now that we have weakening liquidity trends, I find it hard to see the argument for abating risks in this regional banking sphere. To me, it looks like it will accelerate given the underlying momentum in liquidity. But to take one step back, I'd like to look a bit at the balance sheet of First Republic Bank and why it is so important, this deal that JP Morgan struck with the FDIC to purchase the remainings of the First Republic Bank. If we look at a typical bank, the depositor base is the biggest funding source. 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.

6:36First Republic simply needs to replace 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 has to take a loss now, given that this emergency lending cannot be fully covered in the deal with J.B. Morgan. If we look at the details of this deal with J.P. Morgan, I think the so-called loss share solution between the FDIC and J.P. Morgan is interesting. J.B. 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 J.B.

7:36Morgan will take the remaining 20%. So it is a very safe deal, I'd say, for J.B. Morgan. But this is not a sign to take comfort in. If J.B. Morgan is not willing to buy the remainings of First Republic Bank without getting an 80 to 20 split in this loss share agreement, it is probably a signal that they are afraid of losses in the loan book. We know that First Republic Bank has a relatively large exposure towards commercial real estate, but also single family housing in California and elsewhere in the western parts of the US. And the collateral underlying these loans 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 residential real estate.

8:30And the question is whether this is a signal to shareholders and other regional banks to run away. And frankly, that is kind of the mood we get from markets right now that this lost share deal that J.B. Morgan managed to negotiate is not something to take comfort in, And 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 J.P. Morgan deal, it is very, very clear that the market finds J.P. Morgan to be the winner and regional banks to be the losers, potentially also the FDIC to be the loser here.

9:20J.B. Morgan has rallied on the back of this deal, broadly speaking, while we still see this increasing gap between the price development in J.B. Morgan's equity base relative to what we see in the regional banking space. And I think this overarching theme in US 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 had major lines with the Federal Reserve via these emergency lending measures, the Federal Reserve balance sheet also increased during March when First Republic Bank used, for example, the discount window facility to a very large extent.

10:26And at some point, First Republic Bank made up, I think it was 73 % of the total lending in this discount window. And now that J.B. 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 J.B. Morgan. 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.

11:12And this ultimately means that fewer dollars will be around in the banking system. 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 is of such relevance to asset allocation and positioning in markets. And this happens at the same time as the U.S. Treasury is now closing in on the so-called crossover date. Hey, everyone. We're going to take a quick break right now to hear a word from our partners. We'll be right back.

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12:59We'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 US Treasury can no longer fund the federal government operations, will now be moved to 1st of June, maybe even late May. This is something that I've been warning about over the past months, that the 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.

13:49Treasury can no longer add liquidity to any major extent from here. While as soon as we get a debt ceiling deal, the U.S. Treasury also told us yesterday that they plan on issuing a truckload of debt into markets over the course of July, August, September, meaning that they will issue debt and then hold that liquidity at the Federal Reserve 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 Fed balance sheet due to these technicalities around the emergency lending measures. And therefore, the overall picture is now that the U.S.

14:31Treasury 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 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. for the next, say, three, four months. And typically we have a pretty neat correlation between equity returns and the developments in dollar liquidity or the amount of dollars available to private markets.

15:17And 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 if usual correlations hold. And the interesting thing here is that the latest update we received from the Federal Reserve on when to expect the Federal Reserve to accept that liquidity is now adequate relative to the size of the economy 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.

16:08and we're still in between$700 billion and$800 billion from that target, meaning that the Federal Reserve will likely continue to withdraw liquidity for the time being, since their rule of thumb 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 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 flatlining development in liquidity in Europe.

17:00and 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 TL-tros, 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.

17:56And 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, the ECB published this quarterly lending survey today. And as you can see here on the chart, we are now back at crisis levels when it comes to the appetite for loans.

18:58We are 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 expect very similar results. lack of appetite for loans and lack of appetite from the creditors as well, from the banks of giving out, handing out credit. And that is something that typically spills over to activity levels because in our hyper-financialized system, we need credit growth to grow. It is basically as simple as that. So when we look at the European markets, and I'll get back to the U.S.

19:40markets in a second, I think this shrinkage of liquidity into June risks refueling this so-called fragmentation trade in Europe. And what I mean by the fragmentation trade is that peripheral bond yields, so Italy, Spain, Greece, Portugal, will likely suffer relative to co-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.

20:34And if we look at the equity space in Europe, 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 dwindle roughly 1 trillion year over year in Europe into June, we should probably also expect the DAX 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.

21:25But there are a few places on Earth with relatively decent liquidity trends still, one of them being Japan. 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. The can was kicked down the road on their decision to support the yield curve in Japan. And they launched a one-year review of the monetary policy setup, which was initially taken as a sign that Bank of Japan would move nowhere and they 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 yield curve control, so allowing the 10-year bond yield to move higher in the Japanese bond curve, then you should probably also expect them to support the new level, the new cap for the 10-year bond yield with a new bond purchase program to ensure that the market understands that this is a new cap.

22:34So even in such a scenario, I actually think that the Bank of Japan will continue to print new Japanese yen and we have a reasonably 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 Asia than they are in the West and that is something to remain on the watch for when you allocate your portfolio. If we look at the global trends relative to the S &P 500 as the last chart before I move on to the Q &A session, we see kind of a flatlining trend in G6 liquidity.

23:20So here I add the liquidity in China, Japan, Europe, the US, UK, etc. And we saw the bottom back in November last year. We've seen a small rebound. And then we've seen a flatlining tendency. But now that we should expect both dollar and euro liquidity to dwindle by roughly 600, 700 billion worth of euros and dollars, respectively, then I expect global liquidity on aggregate to also suffer. We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

24:05and that is typically bad news for risk assets in the west and therefore i find this liquidity out to warrant a flip towards a more defensive allocation in your portfolio meaning that in equity space health care to stables utilities etc will outperform some of the high risk sectors such as technology and consumer discretionary likely. And now that we have the reporting season mostly behind us, I also think the timing could be right 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 turmoil surrounding regional banks.

24:47And now PacWest is being sold in markets. And let's see whether PacWest can cope with this sell-off on the back of the deal being struck between J.B. Morgan and the FDIC to buy the remainings of the First Republic Bank. So to sum up before we move to the 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.

25:35So 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 equity 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 March and April, then at least a game changer from a portfolio perspective. Let's move on to the questions from the audience. We have a question from Sam here. In this low liquidity environment, what asset allocations would you recommend if converting to cash is not an option? Some investments, such as retirement accounts, cannot be converted into cash without harsh tax penalties.

26:17I think the safest bet here is to look for bonds in the three to five year space in the dollar curve. I also think some of the safer bets would be in healthcare and consumer stables utility stocks. And then it may also be of relevance to add allocations to Asia since the liquidity trends are much more benign in Asia than in the West right now. So, could Andreas comment on where we are with the Waller Rule framework that he proposed a few months ago? I guess I briefly touched upon it during the presentation, but the Waller Rule suggests that you should have 10 % of the gross domestic product 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 stuck above 3 trillion.

27:12So there is still a gap of in between 700 and 800 billion to cover for the Federal Reserve if they want to get to that 2.6 target. I'm personally not sure they will get there. Our great founder of Real Vision, Raul Powell, 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. But short term, they will try to get there. And we basically know the trajectory of liquidity in May, June, and it will not be pretty. Question from Oleg on the debt ceiling. How do I expect it to play out? Well, we essentially know now that time is of essence, given that the crossover date is late May, maybe first week of June, meaning that we have roughly four weeks left until a partial shutdown is needed to keep the federal government afloat.

28:08currently I see no whatsoever signals that they're close to a compromise and given what we've seen 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 in late May early June with a lot of uncertainty around 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 go down right to the wire and I expect the deal to be struck probably a few days after deadline.

28:56Final question from Paul. Could you elaborate on how you differ from Raoul Powell 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 it opportune to do so. And they're currently not discussing that. And on top of that, I also think it is crystal clear what happens to dollar liquidity once the debt ceiling is lifted, because then the US Treasury will rebuild its more chest at the Federal Reserve, and that means withdrawing liquidity from private markets.

29:52I agree with Mike Howell and Raoul Pal on, say, the 6, 9, 12 months outlook for liquidity. This is a tactical view covering May, June, because we have these technicalities leading to a shrinking liquidity picture short term. And those technicalities will not be covered for by QE, not as far as I can see over the course of the next few months, because we simply need a crisis to unfold before QE 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. Time for a final question from Gary. Can the US Treasury primarily issue bills to replenish the TGA, thereby mitigating the liquidity decline by running down the reverse repo facility?

30:45This is a tremendous question from Gary. and I'm actually sad that I did not address this myself. The reverse repo facility 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 money market funds to park the dollars at this facility at the Federal 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.

31:29They typically try to spread their duration risk across the curve, meaning that they will both issue T-bills two-year, five-year, ten-year, etc. and a conservative institution like the US Treasury will not decide on an opportune basis to only issue bills. I can almost guarantee that. So net-net we will see illiquidity withdrawal, but you're spot on. The more bills, the better. And from the communication we had yesterday, my impression is that they will spread the issuance over the curve and not just leave issuance in the very, very shorter bills. I think I will leave it there for this week's edition of StenoSignals.