When times are good, no one wants to believe they’ll ever end.
This behavioral trait is something we all share. It’s called optimism bias, and it can affect people in everything from their personal lives to their careers to their finances.
It can also be dangerous, especially when it seeps into markets. And looking at certain financial indicators, it certainly seems that it has.
On the surface, things don’t look so bad – certainly not if you’re in stocks. But take a deeper look and you’ll sense growing rumblings in the global financial system.
The Red Flags You Need to Watch: M1, M2, and Main Street
In the wake of the Covid-19 pandemic, the U.S. government enacted more fiscal stimulus than all other historical stimulus events combined.
The size and scope of these efforts are difficult to overstate, as the world’s reserve currency rapidly shifted into overdrive in terms of money printing. So much so that a startling 22 percent of all U.S. dollars to have ever existed were printed in 2020.
The piping of the global financial system can only handle so much excess liquidity. The problem is that no entity knows exactly how much liquidity is “too much.”
Tracking The Excess
The United States utilizes a tiered system to track the overall money supply in the economy and the velocity of that money.
M1 is a narrow metric which includes demand deposits, checking accounts, and physical currency. In contrast, the M2 metric tracks “near money”, or assets that are readily convertible to cash.
Despite the accuracy of both metrics in tracking the overall amount of money flowing through the economy, the Federal Reserve discontinued using these instruments in February of 2021.
While the logic behind this decision is unknown, the M1 supply increased by over 400 percent in under one year following the Covid-19 outbreak.
Comparatively, M2 money supply, which tracks “near money,” increased by “only” 33 percent during the same period. The Federal Reserve now opts to track the previous M1 and M2 data monthly rather than weekly, citing correlation issues. The timing of this decision certainly raises some eyebrows.
M1 Money Supply Source: FRED (fred.stlouisfed.org)
Cheap Money, Expensive Problems: the Risky T-Bill Discount
It comes as no surprise that money becomes extraordinarily cheap when it is excessively abundant. One of the first arrows in the quiver of central banks worldwide is manipulating interest rates to drive down the price of money.
The Taper Tantrum of 2013 signaled to global central banks that any shift in intensely accommodative monetary policy would produce disproportionately negative equity market drawdowns.
The causes of this correlation are diverse and highly complicated. Still, the correlation itself remains the primary consideration of central banks — raise rates and the market takes a hit.
For this reason, the slow waltz between the Federal Reserve and global markets has driven Treasury Bill yields down to a puzzling 0 percent.
Commonly known as the only asset offering conservative investors a risk-free return and retirees a chance to enjoy guaranteed modest yields, T-bills now offer no yield whatsoever.
It is important to note that while we’ve gotten close, this has never happened before and suggests that something is seriously wrong with the global financial system.
The Pipes Are Breaking: Repo Market Troubles
When it comes to the inner workings of the financial system, there is perhaps no better authority than Zoltan Pozsar, who helped to construct many of the facilities that oversee smooth lending operations in the global economy.
One such facility is known as the overnight repurchasing agreement, or the REPO, market. In this market, banks buy and sell highly liquid Treasury securities to one another to ensure sufficient overnight capitalization requirements.
In theory, this market is intended to be a boring and orderly market that sees only occasional upticks in seasonal usage. But Pozsar, who likely knows more about overnight REPO markets than anyone else in the world, has noticed some discrepancies.
A recent comment from Pozsar should deeply worry any market participant: “The heavy use of the o/n RRP facility tells us that foreign banks too are now chock-full of reserves.”
Pozsar saw the writing on the wall — the REPO market has been anything but orderly as overnight usage has exploded from a couple billion to over a quarter of a trillion dollars per day.
On May 20th, 2021, overnight usage clocked in at well over $350 billion, signaling serious underlying issues for the global economy.
Despite the best efforts of the world’s largest financial powers, the emerging blockades in the global financial piping continue to raise serious concerns about the overall health of the financial system.
The fact that the Fed feels the need to drain liquidity from the market is concerning for several reasons. First, it means that the banking system can’t handle the excess reserves. Too much liquidity is seeping into equities, inflating markets and creating bubble conditions.
Second, it means that despite claims to the contrary, the Fed is concerned about inflation. They know they’ve gone overboard with quantitative easing and they’re trying to mitigate its effects. But the sheer size of the transactions indicates that they likely won’t be able to.
How Does This All End?
The verdict for the global financial system remains undetermined. Any credible macroeconomic analyst will tell you that while no serious analyst deals in absolutes, the probability of Black Swan events and economic downturns continues to rise.
When the market is bullish, people seem to think that the good times will last forever. But market euphoria can be dangerous – people refuse to see the signs, preferring to live in a risk-free world where all is well.
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