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This is when we feel the repercussions of the earlier Federal Reserve actions to combat a possible financial collapse.
Once the threat of collapse ends, there is more than enough cash around to keep the financial world moving along.
And, during these times, the Federal Reserve is reluctant to “reverse itself” and remove all the cash that it had formerly injected into the financial system.
Last week I wrote about all the cash that was resting in the coffers of venture capital funds.
At the end of July, I wrote, venture funds held a record $539 billion in cash, by far the most cash ever held by these investors.
This week there is evidence that another sector has lots and lots of cash around and is putting these funds to work in the stock market.
Eric Platt writes in the Financial Times that
“Quant funds are increasing their bets on US stock, helping fuel a sharp rally that has added $7.0 trillion in value to markets since June even as economic data point to a slowdown in the world’s largest economy.”
“These funds have spent tens of billions of dollars on futures, helping push the benchmark S&P 500 and tech-heavy NASDAQ Composite up double-digits from recent lows….”
“Nomura estimates that trend-following hedge funds and volatility-control funds have purchased $107 billion of global stock futures since markets hit a low in late June, with a large portion of that used to close short positions.”
Glen Koh, the head of equities trading at Bank of America is quoted as saying,
“With positioning basically at the low there was a lot of cash on the sidelines and so as the market stabilized and started to rally, more and more of this flow has come back into the market.”
This Is The Market The Federal Reserve Has Created
Where have all these funds come from?
Well, they have come from the Federal Reserve.
Since the early 1980s, the federal government, especially supported by the Federal Reserve System, has been following a “credit inflation” effort to keep the economy growing with only a modest amount of price inflation.
The consequence of this, as I have written about many times over the past decade, has been that asset price inflation has become the game of many investors, and this includes many corporate entities who have migrated their companies toward policies associated with financial engineering.
“Credit inflation” became the overt effort of a Federal Reserve led by Ben Bernanke following the Great Recession that ended in 2009, which included three rounds of “Quantitative Easing” where the Fed intentionally conducted its monetary policy to err on the side of monetary ease to avoid any downward mistakes.
Assets prices rose and rose in the 2010s, led especially by stock prices. The decade saw stock markets hit many historical highs as the economy expanded into the 2020s.
Then the Covid-19 pandemic hit, followed by a very short recession.
In order to protect against the impacts of the pandemic, the Federal Reserve injected trillions of dollars of reserves into the financial system.
These funds flowed, wherever. The financial world was flooded.
Many new instruments evolved in this environment.
Some that did very well in the beginning, have not done so well as the environment has changed in 2022.
For example, the SPACs, the Special Purpose Acquisition Companies, did very very well at the beginning of the Fed’s actions and their success spilled over into 2021.
This space, however, is not doing so well at the present time. One report on the problems of these “blank check companies” can be found in the Wall Street Journal.
But, on the whole, the financial system did very well in accumulating cash and continues to sit on amounts that are near historical highs.
For example, the commercial banking system, according to Federal Reserve statistics was holding cash assets of $3.5 trillion on August 3, 2022.
The 25 largest domestically chartered banks in the United States, on August 3, 2022, held $1.5 trillion in cash assets.
This is an amazing amount of “cash on hand.”
And, this is the Fed’s problem, because it is the basic picture of the financial system.
Market Stability
But, can this market hold up?
Mr. Platt quotes Marko Kolanovic, who works as a JPMorgan strategist.
“Strong participation is an indication that this rally is durable, and another expression the market’s tail risks have receded.”
“Volatility targeters can be expected to add exposure overall and especially to equities.”
But, there are still a lot of unknowns.
The big one, as always, is the Fed.
The Future
This is the world that the Fed has created.
The banking system, the financial system, and the economy are flush with cash.
If the Federal Reserve is going to fight inflation, it is going to have to find some way to deal with all the funds that it has pumped into the economy and just sit on corporate balance sheets as “cash assets.”
Federal Reserve officials admit to some responsibility for this pile of cash hanging around.
The Fed has some plans to remove, over the next two years, over $2.0 trillion in bank reserves by reducing the size of its securities portfolio.
Two questions immediately come to mind.
First, is this reduction large enough, because it would still leave over $1.0 trillion in cash assets at commercial banks?
Second, will this reduction take place fast enough to actually reduce the rate of inflation down to around 2.0 percent, the Fed’s target rate of inflation?
There remain a lot of unknowns about how this whole “fighting inflation” battle is going to work out.
Perhaps the most important concern is the one about the ability of this Federal Reserve leadership team to keep sufficient pressure on long enough.
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