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 the start of 2018.
However, that could all change — particularly when you factor in recent uncertainties impacting the markets, which include recession fears, renewed Middle East tensions, and a partially flat yield curve.
Another uncertainty emerged in September that hasn’t received too much attention in the media—though it could be just as significant as any of the uncertainties I just mentioned.
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 up 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, but when they’re short on cash they’ll sell certain securities, like U.S. treasuries, to the Federal Reserve or each other—with an agreement to buy them back sometime 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 Fed uses them to help keep borrowing costs from skyrocketing.
The first repo on September 16 pumped $53 billion into the economy overnight, the next day $75 billion, and the following day another $75 billion, Fortune reported.
What started as a two-week operation has been extended through the end of January 2020, the New York Times reported.
What’s most unsettling about this is that no one seems to have a definitive explanation for the sudden increase in demand for liquidity by US banks. In other words, where did all the cash go?
Federal Reserve Chairman Jerome Powell attributed it to massive cash withdrawals by U.S. corporations to pay their September 15 estimated tax payments, however there are a few reasons why this theory doesn’t hold water. One is that these withdrawals occur every year on September 15, without creating a liquidity crunch. Another is that 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 sudden crunch occurring — so that doesn’t cut it for me either.
I believe someone knows what caused the incident, but no one is talking about it. As an advisor, I get nervous in this kind of situation, because it feels eerily familiar.
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. They had all reinsured one another so once one bank failed, they all came down together.
Until that point, many analysts were predicting the subprime mortgage crisis might be a bump in the road for the economy, but nothing more. It was like an iceberg — some danger was visible above the surface, but the extent of it remained hidden … until we crashed into it.
Is it possible this liquidity emergency in mid-September is evidence that banks have tied themselves together again in some other way?
It seems unlikely to me that so many of our banks would face a liquidity crunch at the same time.
It seems more plausible that the crunch would have started with just a few banks, but impacted the entire system due to an underlying connection we don’t know about yet.
The bottom line is that even though this incident hasn’t received too much attention, it should give investors pause. Could it be early evidence that another financial crisis is brewing? No one knows for sure.
However, with this recent liquidity emergency by U.S. banks being just one of the many skeletons in the world’s economic closet, it’s important to be aware of the potential threat—especially if you’re retired or close to retirement and haven’t adequately reduced your exposure to stock market risk.
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David J. Scranton, CLU, ChFC, CFP, CFA, MSFS, is a nationally renowned Money Manager, Amazon Bestselling Author, national TV Host of The Income Generation, Founder of Sound Income Strategies, LLC, The Retirement Income Store®, and Advisors’ Academy. With over 30 years of experience in the industry, Dave specializes in income-generating savings and investment strategies.
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