January 2, 2019

Down Maiden Lane

For the Federal Reserve, 2018 was the end of the lane. For us, 2019 is fresh and new, and we’re hitting it running.

The market comes stumbling in (anybody remember Suzy Quatro?). The Dow Jones dropped 6% as it did in 2000. The index fell 7% in 2001 and 17% in 2002. The last year blue chips were red was 2015, down 2%.

Everybody wants to know as the new year begins what’s coming.  Why has the market been so volatile? Is a recession at hand? Is the bull market over?

We only know behavior – what’s behind prices. That’s market structure.

Take volatility. In Q4 2018, daily intraday volatility marketwide (average high-low spread) averaged 3.7%, a staggering 61% increase from Q3.  Cause? Exchange-Traded Funds. It’s not the economy, tariffs, China, geopolitics, or Trump.

Bold assertion?  Nope, math.  When an index mutual fund buys or sells stocks, it’s simple: The order goes to the market and gets filled or doesn’t.

ETFs do not buy or sell stocks. They move collateral manually back and forth wholesale to support an electronic retail market where everything, both ETF shares and stocks serving as collateral for them, prices in fractions of seconds. The motivation isn’t investment but profiting on the difference between manual prices and electronic ones.

When the market goes haywire, that process ruptures. Brokers lose collateral exchanged for ETF shares, so they trade desperately to recoup it. There were over $4.1 trillion of ETF wholesale transactions through Nov 2018.

The other $4.1 trillion that matters is the Fed’s balance sheet. If the bull market is over, it’ll be due to the money, not the economy. We have been saying for years that a reckoning looms, and its size is so vast that it’s hard to grasp the girth (rather like my midsection during the holidays).

On Dec 18, 2008, the Federal Reserve said its balance sheet had been “modified to include information related to Maiden Lane II LLC, a limited liability company formed to purchase residential mortgage-backed securities (RMBS) from…American International Group, Inc. (AIG).”

The biggest Fed bank sits between Liberty Street and Maiden Lane in New York. Maiden Lane made the Fed over the next six years owner of seas of failed debts.

Ten year later, on Dec 27, 2018, The Fed said its balance sheet had been “modified to reflect the removal of table 4 ‘Information on Principal Accounts of Maiden Lane LLC.’ The table has been removed because the remaining assets in the portfolio holdings of Maiden Lane LLC have been reduced to a de minimis balance.”

There were at least three Maiden Lane companies created by the Fed to absorb bad debts. At Dec 2018, what remains of these bailouts is too small to note.

Wow, right? Whew!

Not exactly. We used the colossal balance sheet of US taxpayers – every Federal Reserve Note in your wallet pledges your resources to cover government promises – to save us.  We were able to bail ourselves out using our own future money in the present.

We’ve been led to believe by everyone except Ron Paul that it’s all worked out, and now everything is awesome.  No inflation, no $5,000/oz gold.  Except that’s incorrect.  Inflation is not $5,000/oz gold.  It’s cheap money.  We’ve had inflation for ten straight years, and now inflation has stopped.

Picture a swing set on the elementary-school playground. Two chains, a sling seat, pumping legs (or a hand pushing from behind). Higher and higher you go, reaching the apex, and falling back.

Inflation is the strain, the pull, feet shoved forward reaching for the sky.  What follows is the stomach-lurching descent back down.

We were all dragged down Maiden Lane with Tim Geithner and Hank Paulson and Ben Bernanke. They gave that sling seat, the American economy, the biggest shove in human history. Then they left. Up we went, hair back, laughing, feet out, reaching for the sky.

Now we’re at the top of the arc.

The vastness of the economic swing is hard to comprehend. We spent ten years like expended cartridges in the longest firefight ever to get here. We won’t give it up in a single stomach-clenching free-fall.

But the reality is and has always been that when the long walk to the end of Maiden Lane was done, there would be a reckoning, a return to reality, to earth.

How ironic that the Fed’s balance sheet and the size of the ETF wholesale market are now roughly equal – about $4.1 trillion.

It’s never been more important for public companies and investors to understand market structure – behavior. Why? Because money trumps everything, and arbitraging the price-differences it creates dominates, and is measurable, and predictable.

The trick is juxtaposing continual gyrations with the expanse of Maiden Lane, now ended. I don’t know when this bull market ends. I do know where we are slung into the sling of the swing set.

It’s going to be an interesting year. We relish the chance to help you navigate it. And we hope the Fed never returns to Maiden Lane. Let the arc play out. We’ll be all right.

 

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