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Posted by on Mar 13, 2020 in TG Roundup

The $1.5 Trillion Liquidity Pump: Explained with an Analogy

[This post was originally posted on Mohan Venigalla’s Facebook page on Friday, the 13th at 7:15 AM. It is edited and enhanced at 6 PM on Saturday, 14th March at 6 PM].

If the bank pays you 0.75% if you BORROW FROM them, would you borrow? How much? (I would and I would hit the limit – whatever that is). Well that is what ECB has announced TODAY. This is a part of subsidy measures by the ECB, a measure to keep banks lending. And a silent approval to use more of their capital, not as insurance against risk, but to do business. The ECB is also hinting that they will stand by to buy sovereign debt of their member countries.

Yesterday (Thursday, March 12th): The Federal Reserve Board infused (via repos) an unprecedented $1.5 trillion into the lending system. Plus, $60 billion of monthly repurchases

Contrary to what you may have heard, this is NOT A BAILOUT of the banks and Wall Street

  • They did not SPEND $1.5 trillion
  • It did not cost American citizens $1.5 trillions

What does this all mean? I will try to explain with this analogy.

Think of a farm (a nation’s economy), and its operations in these lines..

  • there are milking cows on the farm (businesses),
  • there is a big pond on the farm (the banking system other capital markets)
  • the cattle go to drink from (capital via borrowing) from the pond,
  • a lot of the cows are sick due to a pandemic (Coronavirus),
  • grass (supply) is also dying due to drought (risk aversion to lend)
  • the sick cows need plenty of water (capital),
  • for some cows that drank too much water (companies loaded with debt) the disease is deadly and drinking more water is also deadly,
  • for other cows drinking water is essential,
  • the pond is drying up due to drought (contracting economy)
  • some cows are not having enough water to drink (Boeing and a few other companies tapping into their credit line early this week)
  • the farmer (here it is Feds) pumps $1.5 trillion gallons of water into the pond to address the ‘lack of water’ problem

That’s the set up. Now the questions that need answers to:

  • Will the cows recover? How many will die? How many will recover?
  • How many cows will need the water from the pond?
  • How many will go to the pond to drink if the path to and from the pond is risky (risk).
  • You may have the pond full of water, can you make the cows drink?
  • Will the farm be able to keep its dairy production going? (GDP)
  • It is clear now that the milk production is negatively impacted (recession), but by how much?

I don’t know the answers to above questions. But I know the answer to these questions.

  • Will the cows that already drank too much will come back for more? (misuse) YES
  • Will thieves (banks) drain some of the water to their benefit? (abuse) [100% certain]

Here is a scenarios where part of this $1.5 trillion will help

  • Market goes down, you freak out, pull money out of mutual funds and into money markets in your 401 Ks (redemption)
  • Your 401K custodian (broker) may not sell anything, but will commit to giving you the cash.
  • The custodian reaches out to its own cash reserves OR a third party for a short term loan to pay for that redemption
  • More people do the same. And then even more. The custodian and his lender (counter party) are overwhelmed. These two are possible (and are happening this week)
    • Forced selling of stocks (custodian)
    • Defaulting on loans to the counter party
  • The counter party credit spreads were severely stressed
  • The lending markets are tight for money everywhere
  • The lender of the lost resort? The Federal Reserve Board. Their pond of $1.5 trillion repos.

Do not underestimate the positive impact of this Feds action on market – especially on triple witching week ending March 20. Me thinks that stock markets will stage a huge rally into Friday, March 20. (Of course, I could be totally wrong. The Coronavirus-related news could be so bad the market may even collapse. But, I doubt if we are at that point now.)

-Mohan