Unhedged

This is an audio transcript of the Unhedged podcast episode: ‘Down the liquidity hole

Ethan Wu
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 wanna talk about another theory of what’s going on. A weirder theory. It’s the theory of liquidity.

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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
I think of myself as the Mobius of liquidity. Remember that — Fishburne’s character in The Matrix?

Ethan Wu
Morpheus. Not Mobius. Morpheus.

Robert Armstrong
Was it Morpheus? Whatever. Fishburne. That’s the character. (Ethan laughs) Long black leather trenchcoat, sunglasses. That’s me.

Ethan Wu
Oh, man. Do you have a red pill to offer me?

Robert Armstrong
Yes. Well, let’s start with the blue pill. And 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 realise none of that stuff matters. What really matters is the amount of money or liquidity that is trapped in the financial system.

Ethan Wu
Oh, man. These are some deep, dark truths that I’m not prepared for.

Robert Armstrong
I’m telling you, Coppertop. Once you start seeing the truth, you’re gonna see it.

Ethan Wu
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 10-11 per cent 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 risky assets. And I kind of offhand in 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
Yeah. She thought you were talking about the grassy knoll or something like that.

Ethan Wu
But there is something 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, when, specifically when investors and money market funds withdraw cash from it, it injects liquidity into the system. That Fed facility that holds all this liquidity . . . 

Robert Armstrong
Extra cash.

Ethan Wu
Extra cash.

Robert Armstrong
It’s a cash sponge. 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
That’s right.

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

Ethan Wu
A remarkable rate. So just at the beginning of the year, this reverse repo window held around $2.3tn in cash. That’s a lot of money, $2.3tn. Today, 11 months later, it is at $914bn. That’s a 60-plus per cent decrease, which means that $1.5tn or so has been injected into US financial markets.

Robert Armstrong
Yes.

Ethan Wu
It’s a big change.

Robert Armstrong
And here’s why that forces assets up, right. The theory, the liquidity theory goes like this: I am an investor and I have some ideal balance of assets in my head that I want, like, maybe I’m a fund manager or maybe I’m a person, a household, and I think I want this much in real estate, this much in stocks, and I want this much cash as a buffer, as a risk buffer, and maybe depending on whether times are good or bad, I want more or less cash. But if you force cash into the financial system, it ends up in these portfolios of investors, whether institutional or household or whatever. And suddenly my portfolio is out of balance. I have too much cash. So I gotta buy something else. I got to go chase stocks or real estate or bonds or whatever just so my portfolio is in the balance I need it to be in. Here’s the punchline. It’s futile because any time I spend cash on a stock, I’ve just moved the cash out of my pocket into your pocket. You sold me the bond or the stock or the piece of real estate. Now you got the money, and now you’re like, God, I got to get rid of this money. And so we’re sort of passing, futilely passing all this extra cash around. And the side effect of that is higher asset prices, more transactions.

Ethan Wu
That’s right . . . Rob, I think it’s important to make a distinction here and say that we are talking about the connection between liquidity — cash in the system — and stock and asset prices, not the connection between liquidity and general inflation for goods and services or food or rent or whatever. That’s not what we’re talking about.

Robert Armstrong
Milton Friedman said inflation is always and everywhere a monetary phenomenon — amount of money, amount of goods. And in general, that applies to inflation as we all know it and the liquidity theory of asset prices. The big difference is where the money is. The point is that the money we’re talking about is mostly trapped in the financial system. It comes from governments, most famously the Fed, who control the amount of money in the system by buying and selling assets themselves as practised by the Fed or the ECB or the Bank of Japan or the People’s Bank of China. And that money goes first to banks and then on to investment portfolios. And it’s kind of trapped within a system. It doesn’t leak out very easily into the general economy, which is actually one of the great criticisms of quantitative easing, right, is that we did all this QE and we jammed all this cash into the system in the hopes of getting general economic growth. And we didn’t. We had slow economic growth and wild appreciation of financial assets. The impact of QE was to just make people who own a lot of paper assets richer. And the liquidity theory of asset prices, people say, yes, you’re finally getting it, right, what this is really all about. You introduce this money into the system. It gets trapped in the financial system. It chases financial assets around. And it’s this weird effect that happens next door to the real economy, not to the real economy.

Ethan Wu
So I think we’ve laid out some of the theory for why people think there is a link between liquidity changes and stock price changes. There’s a lot of practical problems, though, in establishing a clear link and making predictions about where stock prices are gonna go. It’s not easy to predict stock prices at all on any basis, on any theory. However, if you look at something like the change in bank reserves, right, the amount of cash that commercial US banks hold at the Fed, that has a pretty strong correlation with what the S&P 500 does.

Robert Armstrong
You chart those two against one another. Reserves go up. Because money’s entered the system, stocks go up.

Ethan Wu
Yes. And on Wall Street, we love correlations, don’t we, folks? We love when two lines travel together. It’s amazing.

Robert Armstrong
Yeah. That’s the business we’re in.

Ethan Wu
It’s the holy grail. And I think that’s why this liquidity theory of stock prices is so kind of inescapable if you spend enough time hanging around on Wall Street.

Robert Armstrong
Look at that, you’re looking at a chart of the Fed balance sheet against a chart of the S&P 500. And boy, do those two things seem to travel together. But you wanna predict the future, though, right? What happens next?

Ethan Wu
Oh, God, no. Oh, man, listen, I wish I knew. But what I can tell you is what has happened, which is in November, commercial bank reserves held with the Fed have increased around 6 per cent at the same time that stocks have gone up around 10 per cent on a trailing four-week basis. That’s pretty notable and makes you wonder how much economic fundamentals are driving the stock rally.

Robert Armstrong
Yeah. So the punchline for people who follow stocks here is you can stop worrying and trying to predict what’s gonna happen to company fundamentals or the economy and concentrate more of your efforts on thinking about, OK, what’s the Fed gonna do next? Is it gonna make its balance sheet smaller or larger? What is the Bank of Japan going to do? What is the ECB going to do? You can try to predict the policy decisions that are gonna drive liquidity and manage your portfolio appropriately. And so one very classic thing that Wall Street strategists have been saying for several years now is the Fed is doing quantitative tightening. They are selling bonds instead of buying them. And that is going to be a headwind for asset prices, right?

Ethan Wu
Right. That is one of the curious things, is that we’re supposed to be in an environment where liquidity is diminishing, right, because the Fed is doing quantitative tightening. It’s shrinking its balance sheet. That, all else equal, is supposed to suck cash out of the system, reduce the amount of reserves and in theory, put pressure on asset prices. The relationship has not been that straightforward, though, for a variety of reasons.

Robert Armstrong
Well, you mentioned the first is the RRP.

Ethan Wu
The reverse repo window is a really important offsetting pressure. The other one is that earlier this year we had Silicon Valley Bank fail spectacularly and the Fed set up this facility called the Bank Term Funding Program, basically like a mini QE to support the banking system. And that also kind of counteracts what QT is doing. It’s injecting more cash into the system to make sure banks are OK.

Robert Armstrong
And the buy case from the liquidity theory is that the governments of the world are bad at their jobs. They cannot do fiscal policy effectively. Everybody is throwing mud at one another and fighting about things. And so the only people really managing the world’s economy are the central banks. And they basically have rates and they have money creation as their tools. So every time the world is gonna run into trouble, because the only tool they have is monetary policy, they’re gonna turn that knob. And like, so a bank fails? Let’s turn on the liquidity.

Ethan Wu
Yeah.

Robert Armstrong
Or, you know, the economy’s slowing down? Let’s turn on liquidity. And this is a fairly bad tool because as we’ve just explained, it affects asset prices more than it does the real economy. But that’s what they’re gonna do. So on that view of the world, just own financial assets. Don’t worry so much about the economy. Is it going up? Is it going down? It’s going sideways. There’s gonna be liquidity injection into the system because that’s the only management tool the world has. That’s gonna help your asset portfolio. The moral of the story, Ethan, is, as a rule, be rich.

Ethan Wu
(Laughter) That’s the real red pill.

Robert Armstrong
Yes.

Ethan Wu
So we’ve laid out this liquidity theory. We’ve talked a little bit about some of the practical challenges that it’s kind of hard to know where liquidity’s going. There are different measurements for how you think about liquidity. How much stock do we put in this versus a traditional finance 101 idea of stock prices that they’re just, you know, like a bunch of cash flows into the future, right? You wrote a piece today, Rob, from a reader who works at a quant shop, kind of making the case against a liquidity view of the November rally.

Robert Armstrong
It’s really hard theory to disconfirm.

Ethan Wu
(Laughter) Sorry, what?

Robert Armstrong
OK. So the liquidity theory is really hard to prove wrong. Let’s put it that way. And you should be suspicious of any theory that has that property. A good theory, you can say let’s put it to the test and see if it’s right or wrong. The problem with the liquidity theory is that it is general enough
that you can kind of see it everywhere, that every preference or financial activity can be kind of interpreted as a response to the money supply, the financial money supply, specifically. So I think my level of conviction is it’s clearly important. But I’m slightly suspicious of how powerful a tool it is for predicting the future or making financial decisions. I’m not quite sure how much ice it cuts, but it’s, in some sense, it has to be right.

Ethan Wu
Yeah.

Robert Armstrong
We know that the amount of money in any system, whether it’s the real economy or the financial economy, has to matter in some sense to price levels, right?

Ethan Wu
It would be weird if it were wrong. That’s kind of how I think about it. It’s a background force. Liquidity either raises the bar or lowers the bar for a stock rally, but it’s not ultimately what does it. You know, there has to be an investor somewhere, a computer or a person pulling the trigger. And that, I think, is probably a function of sentiment, right, how people feel about stocks. And that in turn is informed by fundamentals, by profits, by the state of the economy.

Robert Armstrong
That’s a really good way to think of it. And again, let’s return to that image of the investor who’s trying to get the right balance in their portfolio. They want a certain amount of cash, certain amount of bonds, certain amount of stock, certain amount of real estate that they’re balancing around. There is a question of how much cash is in the system that is landing in those investment portfolios.

But the second aspect of the theory is how much cash each investor feels like holding, and that’s informed by sentiment, and sentiment is informed by economic reality. So you have the volume of cash and the positive or negative feelings that investors have. And those are the two aspects of liquidity theory. So one of my favourite phrases is: What is a bear market in stocks? It’s a bull market in cash. So when investors are scared, they want to have more cash on their portfolio versus less. So it’s not just the quantity of liquidity that matters, it’s the desire for liquidity. You have to somehow strike a balance between those two things. So you might say liquidity is half the picture.

Ethan Wu
Yeah. And, you know, it’s the problem with taking the red pill is that sometimes it’s useful to see the blue-pill world, you know? Like, you need to see both worlds. You can’t just see one.

Robert Armstrong
I’m probably on Team Red. (Ethan laughs) Sir, is there a purple pill available?

Ethan Wu
Can I take both? Like, why isn’t that an option?

Robert Armstrong
Oh, don’t take both. Bad things happen then.

Ethan Wu
I medicate away my problems. I take more pills when I need to. All right, Rob, we’ll be back in a minute with Long/Short.

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Welcome back. This is Long/Short, that part of the show where we go long a thing we love, short a thing we hate. Rob, you long or short something?

Robert Armstrong
I am long the late, great Charlie Munger — number two at Berkshire Hathaway, who died at the regal and stately age of 99 this week. He was the man. And I say that not for the reason that everybody else says it, which is that he was a brilliant investor who helped make Berkshire Hathaway the towering financial success that it is, but because he is A) hilarious and B) he really was the right kind of rich person. There was this great quote I read for him in one of the obituaries, which was he said, I was always highly motivated to be rich because it struck me as undignified to invoice people. It seems to me that’s exactly the right attitude towards money, which is what is it for? It’s not to have more stuff or to show off or to dominate other people. It’s to be the person that you want to be without constraint. And I think he really personified that. I am long him all day.

Ethan Wu
RIP to Mr Munger. Rob, I’m short things being partially broken. I think things should either be broken or not broken. When they’re stuck in between, it’s very annoying. And I bring this up because both my dryer and my internet connection are partially broken, which is the worst kind because when the mechanic comes by, they’re like, it’s not broken, it’s working. And you’re like, no, it was broken an hour ago. And they don’t believe you. It’s the worst. Just break. I’d like it to just break.

Robert Armstrong
Never good, stuck in the middle. Yeah, that is a powerful metaphor for life, Ethan.

Ethan Wu
(Laughter) If you’re gonna break, break all the way.

All right, Rob, thanks for being here. Hopefully we will be fully broken or fully healed by the next time you’re on the show. And listeners, we’ll be back in your feed on Tuesday with another episode of Unhedged. Catch you then.

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Unhedged is produced by Jake Harper and edited by Bryant Urstadt. Our executive producer is Jacob Goldstein. We had additional help from Topher Forhecz. Cheryl Brumley is the FT’s global head of audio. Special thanks to Laura Clarke, Alastair Mackie, Jacob Weisberg and Jess Truglia. FT Premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com/unhedgedoffer. I’m Ethan Wu. Thanks for listening.

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