Most people look at the stock market as a sign of the health of the economy. If the stock market is moving higher in value, things must be good. The truth of the matter is that the stock market isn’t as important as the debt market, specifically the interbank debt market.
What goes on in the interbank market has a direct effect on what happens in the stock market. A healthy interbank market gives the stock market the footing it needs to sustain a rally. When it breaks, as we saw in 2008 and in March 2020 during the COVID-19 pandemic, the stock market drops precipitously.
The interbank debt market is the market for money and loans between banks and between those same banks and the Federal Reserve. It’s called the overnight repo market. The Fed uses open-market actions such as customer repos and reverse repos to add or take liquidity out of the market. Banks make overnight loans to each other.
Big institutions that have excess cash on their balance sheets also execute trades in the overnight repo market to grab a little more yield overnight. The market valuation is in the trillions of dollars.
When we have huge drops in the stock market value, it’s usually because there’s some sort of ripple tearing through the interbank debt market. In 2008, banks didn’t trust each other’s balance sheets, and the market froze, drying up all liquidity with the corresponding drop in stocks.
If the interbank market is any guide, we appear to be headed for some rough and volatile sledding in the stock market. The increase in the debt ceiling means that the Fed is going to issue $1.4 trillion in new debt between now and the end of the year. Who’s going to buy that debt?
This has always been a conundrum for the market. But today, some of the largest potential foreign buyers of our debt aren’t being as accommodating. U.S. pension funds and other U.S. funds hold the lion’s share of U.S. debt, but it’s unclear if they want to buy a lot more at current prices. There’s uncertainty, and that creates volatility.
The cash that’s currently flowing into the reverse repo market will flow into some of those Treasurys, but the problem is that the market is an overnight program. Treasurys are longer-denominated instruments. Liquidity is going to flow out of the system at a rate we haven’t seen for a long, long time, if ever.
When this happened before, we didn’t have the inflationary pressure created by massive government overreach and spending during COVID-19 and post-COVID with the first Biden budget that we have today. Coming into an election cycle, it will be impossible for the government legislative bodies to solve the lack of liquidity. The Fed will be in a very tough spot to try to solve it since it’s the inflation fighter now. Creating more liquidity will spur higher rates of inflation.
Not only that, but the Fed has to be worried about unemployment. Data show that in places such as Costco, customers are buying more chicken and pork than beef. Is that a change in consumer preferences or is it a sign of recession? States including California have seen tax revenues plummet. Is that a sign of recession or that startups have laid off people and people have fled the state? All this creates more risk in the stock market, but currently, we’re witnessing a relief rally after the manufactured debt-ceiling drama. Right now, the VIX, a measure of risk in the stock market, is collapsing to year lows.
If the near-term SOFR contract starts to aggressively get bid up in value and seems disjointed with the rest of the debt market, it’s a sign that banks don’t want to lend to each other and that there’s a lot of fear in the market.
The problem for anyone is that you can’t time when something might happen. I’m not the only person who has seen this, and I credit RJR Capital for broadcasting it on Twitter. Economists such as David Rosenberg have said that there’s a tidal wave forming and that it looks like it will hit the beach.
Buckle up, then, and don’t listen to the mainstream media when it comes to happy or sad talk about the stock market. They don’t see it coming. But it looks like it’s coming.
