I have spoken about bipolarity in the market, the prevailing risks, the mountains of debts, the shorts, and so much more, but perhaps most OPAQUE of all is this financial engineering stuff that is happening in the finance world that little do we common people have the faintest clue nor understanding- it is stuff you watch in the movie The Big Short. You may have heard a few months back about the repo issue that ended with the Fed doing an unofficial QE4- that may not be the end of it because it signifies potential underlying problems in the financial plumbing system. Zero Hedge in the article below carries the story (but don't worry I don't understand 80% of it too) about this financial czar Zoltan Pozsar cautioning about a potential near term implosion as the US financial system face probable liquidity squeeze.
Putting all of the above together, and for those unfamiliar with the nuances of the repo market this summary may be a critical catch up, the risk to the "benign and optimistic view" currently prevailing among market participants, is mostly as related to the FX swap market: given that i) excess reserves are gone and ii) the G-SIB scores bind, "the FX swap market, unlike last year-end, may end up without a lender of next-to-last resort, and so it will likely trade at implied rates far worse than anything that we’ve seen in recent year-end turns."
In this dystopian world described by Pozsar, in which banks have too much "collateral" (Treasuriess) on their books, and not enough "reserves" (cash), where big commercial banks are unable to lend out to the rest of the banking system as they themselves don't have enough reserves, and where there will be an added pressure to boost reserves in the last days before Dec 31, Pozsar's big picture conclusion is that "the safe asset – U.S. Treasuries – is being funded o/n and therefore it depends on balance sheet to be held and printed. Balance sheet for the safe asset isn’t guaranteed around year-end and if balance sheet won’t be there, the safe asset will go on sale."
Translated: "Treasury yields will spike", Pozsar warns, identifying the trigger of forced sales of Treasuries around year-end as the FX swap market. It gets worse, because the selloff that is triggered by a freeze in the FX swap market will promptly lead to a crash in the bonds market, and spread from there, or as Pozsar puts it, "these funding market stresses will likely pull away capital and hence balance sheet from equity long-short strategies which could spill over into a broader equity selloff… during a Treasury selloff – that’s not the right kind of risk parity Christmas."
Which brings us to punchline #1: the dismal liquidity situation within the US commercial bank sector is so dire, that the shortage of reserves will start a cascade of liquidations beginning in the FX swap market, progressing to Treasurys, and culminating in stocks... and a full-blown market crash.
When these pressures will show up and how long they will last is the last big question asked by Pozsar and as he answers,
"here it’s hard to have a definitive answer: it depends. It depends on how equities do, which depends on the trade deal and other random tweets. It depends on how auctions go, which depends on the equity market and the curve slope relative to actual funding costs."
In conclusion all we can say here is that 11 years ago, on September 5, 2008, ten days before Lehman filed, there were massive marketwide repo problems (recall the repo market froze in Sept 2008 and only a multi-trillion bailout by the world's central banks prevented civilization collapse) and almost nobody understood them... with one exception: Citi's Matt King did and he laid out all the problems in his iconic Sept 5, 2008, piece "Are the Brokers Broken" in which he predicted the collapse of Lehman. Ten days later he was right. Will Zoltan Pozsar be this generation's Matt King?
Zoltan is talking about this possibility in the run to the year end, which means this is a risk event of a Black Swan nature that could happen before the month ends.
Now whether this will or will not happen, it does not take away the fact that like it or not, as investors we have to contend with these sorts of Black Swan type sh*t that will affect our investments (because they could bring about the collapse of the House of Cards). Another reason why the equity markets have becomes less investable - the fall in your stocks could have little to do with anything your company does or does not do. We are like the lambs to the slaughter when the financial markets face their major cock-up!
