Down the liquidity hole

SPEAKER_1 (0:01)

The systemic risk in the economy is affected both by levels of consumer debt and federal debt. They don't necessarily interact directly, but high levels of debt across the economy can create risks for stress in the financial system, perhaps ultimately instability in the financial system.

SPEAKER_2 (0:20)

To hear more about potential impacts of our increasing federal debt level, subscribe to P-Gym's The Outthinking Investor in your favorite podcast app.

Ethan Wu (0:29)

Thank you.

Pushkin.

The economy is slowing, and yet stock prices are rising. What the hell is going on? We talked a little bit on Tuesday with Katie Martin about one idea, the classic idea, that interest rate cuts are coming, the market's pricing them in, and that pushes stock prices up. But today on the show, we want to talk about another theory of what's going on, a weirder theory. It's the theory of liquidity. This is Unhedged, the Markets and Finance show from the Financial Times and Pushkin. I'm reporter Ethan Wu, here in the New York studio, joined today by liquidity maven, Robert Armstrong.

Robert Armstrong (1:15)

I think of myself as the Mobius of liquidity. Remember that Fishburn's character in The Matrix?

Ethan Wu (1:22)

Morpheus, not Mobius, Morpheus.

Robert Armstrong (1:25)

Wasn't it Morpheus? Whatever, Fishburn, that's the character.

Long, black leather trench coat, sunglasses, that's me.

Ethan Wu (1:33)

Oh man, do you have a red pill to offer me?

Robert Armstrong (1:36)

Yes. Well, let's start with the blue pill. In the blue pill, which you sort of talked about on the last show, the reason that financial assets like stocks and bonds go up is because of economic fundamentals.

What is the Fed's interest rate policy? How fast is the economy growing? How much profit are the companies making?

But when you take the red pill, the liquidity pill, you realize none of that stuff matters. What really matters is the amount of money or liquidity that is trapped in the financial system.

Ethan Wu (2:11)

Oh, man, these are some deep dark truths that I'm not prepared for.

Robert Armstrong (2:14)

I'm telling you, Copper Top, once you start seeing the truth, you're gonna see it everywhere.

Ethan Wu (2:19)

Can't unsee it. Well, let's talk about why we're talking about this. You referenced last show on Tuesday with Katie Martin, where we talked about the 10% to 11% stock market rally in November.

And we had that conversation very much in terms of how interest rates are coming down and yeah, the economy is slowing, but once the Fed cuts, that should give a lot of relief to stocks and other risk assets. And I kind of off-handed that show mentioned, well, there are some people that think there's another explanation through liquidity. And Katie Martin gave me a little chuckle like, oh yeah, there always are those people.

Robert Armstrong (2:50)

Yeah, she thought you were talking about the grassy knoll or something like that.

Ethan Wu (2:53)

But there is something that has changed and that has changed recently that I think is behind a lot of the discussion of liquidity as a potential driver of this rally. There's this very obscure Fed facility that we're not going to get into in any detail because it's too complicated, but it's called the reverse repo window. It's basically a big liquidity piggy bank, a bunch of dead useless cash goes and sits there, which means that when cash gets withdrawn from that, specifically when investors at money market funds withdraw cash from it, it injects liquidity into the system.

That Fed facility that holds all this liquidity.

Robert Armstrong (3:30)

Extra cash.

Ethan Wu (3:31)

Extra cash.

Robert Armstrong (3:32)

It's a cash sponge.

Ethan Wu (3:34)

Cash sponge.

Robert Armstrong (3:35)

When the Fed judges that there is too much cash sloshing around the system, they will basically say to investors and money market funds in particular, hey, we'll hold your cash at this attractive rate, give it to us and we'll hold on to it for you. And that pulls money out of the system.

Ethan Wu (3:52)

That's right.

Robert Armstrong (3:53)

And right now, they're releasing money into the system at quite a strong rate.

Ethan Wu (3:59)

A remarkable rate. So just at the beginning of the year, this reverse repo window held around 2.3 trillion US dollars in cash. That's a lot of money, 2.3 trillion dollars.

Today, 11 months later, it is at 914 billion. That's a 60 plus percent decrease, which means that trillion and a half dollars or so has been injected into US financial markets.

Robert Armstrong (4:22)

Yes.

Ethan Wu (4:23)

It's a big change.

Robert Armstrong (4:24)

And here's why that forces assets up, right? The theory, the liquidity theory goes like this.