Liquidity: Not in California or the markets

Liquidity — the lubricant of markets — appears to heading for California drought status.

Volume use to be a good way of measuring liquidity. The breath and depth of the US markets was second to none as measured by volume back in the day.

That day has passed as volume is waning and what volume there is in the form of algorithms. The high-frequency trading of catching a few pennies profits does not constitute liquidity, despite what HFT industry types purport.

Lack of liquidity means higher volatility as money becomes tighter. In its most destructive force lack of liquidity brings down a Bear Stearns or Lehman Bros.

Corporate debt markets are experiencing a tightening as institutional investors search for yield in a crowded trade. GE’s announcement of the sale of its GE Capital unit sent shivers through the system as the firm announced it would be curtailing its offerings prior to a sale.

GE Capital is a huge issuer of corporate debt as well as a buyer. This is a large drain on liquidity and yields went noticeable higher on the day of the announcement.

The Federal Reserve and its zero interest rate policy and Dodd/Frank are the two main culprits in this scenario.

ZIRP is retarding liquidity by skewing the debt markets severely. Uncle Sam is still the 800-lbs gorilla in the debt markets.

Dodd/Frank has taken many of the biggest liquidity providers — Wall Street trading desks — out of their meaningful role in the markets. Prop trading is but a fraction of what it was before 2008.

Smaller broker dealers and Hedge fund shops cannot and will not provide the lost liquidity.

This needs to be watch carefully and is another large reason why the Fed is between a rock … Because its ZIRP policy is the problem but it cannot look to undo it by raising interest rate without finding other sources of liquidity.

 

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