Fed monetary policy has become captive of financial markets, writes Henry Kaufman
Financial markets depend heavily on the concepts of liquidity and negotiability. But these two market dynamics no longer work as they once did. Failure to understand the real underlying constraints on liquidity and marketability when dealing with large blocks of assets can lead to serious miscalculations.
At the start of the post-World War II period, liquidity was understood to encompass easily convertible assets such as cash on hand, holdings of treasury bills and commercial paper, and open bank lines of credit. But over time, businesses and investors have come to define liquidity in terms of a company’s borrowing capacity. To borrow, companies typically issued short-term securities, borrowed short-term from banks, and had back-up lines of credit.
Much of this activity was intended to help companies navigate seasonal or cyclical periods of relative capital scarcity. They expected to pay off their short-term obligations in a matter of weeks or, at most, a few months. In practice, an increasing number of companies have renewed these instruments, so that, from a fundamental or operational point of view, their short-term debts have become sources of long-term liquidity. So, in today’s markets, short-term liabilities are actually long-term liabilities because they are rarely repaid.
As for marketing, it too has changed in ways that are not widely understood, although all market dynamics depend on it. Even the simplest aspects such as bid and ask prices are part of the marketing lexicon. Today, there are pricing services for large portfolios, analytics to judge values within and among many of the components that make up our various market groups, and theories that depend on the validity of marketing. Nevertheless, the concept is flawed and its weaknesses become more and more apparent as the structure of the market itself evolves.
Certainly, the market price of a security depends on the size of the market, its maturity, its credit quality and its size. Many take the simplistic view that securities can be sold at a level close to the price of the last trade. But the selling price depends on all the variables I wrote down. The size of a security alone will significantly affect marketability. After all, how much trading can you actually do to seize an opportunity suggested by a simple yield spread between two stocks, and what value will that add to a large portfolio?
Here are some other shortcomings in marketing. When lower credit quality assets enter the market, the buyer never receives an estimate of the future magnitude of the trading range under varying market conditions. When there is a high concentration of investments in relatively few institutions, the marketability of such a large pool of securities is reduced. Under these circumstances, who will actually participate in the market?
Financial concentration compounds this problem by reducing competition between market makers. And the growing concentration in finance and the non-financial sector is bound to lead to greater government intervention in the financial intermediation process and a greater role for the Federal Reserve in providing liquidity.
Negotiability also plays a central role in the efficient allocation of capital, although the foundations of negotiability are somewhat elusive. Indeed, only a small fraction of tradable issues in circulation is ever traded, while the preponderance of remaining issues is dormant but is valued by the relatively low percentage that is traded.
Ultimately, the idea that large assets can be liquidated easily is just an illusion. In fact, the larger the market participant, the less likely that participant is to liquidate at any kind of predictable price.
It seems clear to me that the combination of deteriorating credit quality, elusive marketability and high financial concentration has increased the central bank’s role as lender of last resort, a trend greatly exaggerated by the pandemic. To some extent, market participants may be aware of this reality and have concluded that declines in fixed financials of, say, 20-25% will be offset by strong monetary easing. Traditionally, central banks are expected to play this role when markets are in dire straits – that is, when marketability becomes dysfunctional.
Market participants are aware of this or have relearned the lesson of the 2008 debacle. Indeed, given the events of 2008, the general market expectation is that the Fed will act faster and more decisively next time around, thus limiting the downside market risks. This suggests to me that monetary policy has become more captive than ever in the financial markets.
Henry Kaufman is the author of several books on business and finance, most recently, “The Day the Markets Roared: How a 1982 Forecast Sparked a Global Bull Market. ”
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