A 2nd Great Depression?

Falling in the Liquidity Trap

May 3, 2020 · Coronavirus,Economics,Economic Trends,Stock Market

Falling in the Liquidity Trap

After suffering four circuit breakers in March due to panic from the Coronavirus epidemic, the S&P 500 closed out April over 12% percent higher. April was one of the largest returns the market has seen in a single month.

Was this due to forward looking investors who eye an end to the crisis or an ocean of liquidity that the US government has dumped on the markets?

Being grateful to the Federal Reserve’s quick response to one of the biggest pandemics in history, Wall Street was filled with hot money in April.

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Although the long-term effect of addressing market liquidity will be satisfiable, it is hard to know if such stimulus is working well in the short run and the question must be asked as to whether this mountain of money will misguide the economy to a liquidity trap?

A liquidity trap describes a situation in Keynesian economics when the interest rates are near zero and investors don’t want to hold debt because there is no yield.

So investors clamor for cash over a market with virtually no yield. In this situation the monetary policy loses efficacy as the intention of propelling scared investors back into the market fails.

It is the hitch in the process of turning monetary liquidity to funding liquidity.

On one hand, there are signs showing that we may be in the trap?

A marker of a liquidity trap is the near-zero interest rate. There was a liquidity trap during 2009/2010, in the immediate aftermath of the global financial crisis. Now we are in a similar state.

Though the S&P 500 has recovered a lot of its losses from the sell off, the Russell 2000, a representative small-cap index, did not. The Russell 2000 experienced a return of around -11% from the beginning of March to the end of April.

Why? Cash is king.

But now small and mid-sized businesses lack the cash to pay for their accounts payable, especially in the services and retail industries.

Even some big plants are struggling for funding liquidity. An increasing number of companies have had to shut down branches, lay off workers or even file for bankruptcy protection. All sectors have been affected.

On the other hand, monetary policy is indispensable in the current situation.

Due to the public health crisis, millions of citizens are losing their jobs, while farmers are dumping milk and euthanizing their animals.

The high unemployment rate and economic recession are signals for a rescue. Obviously, a $1200 stimulus check is not enough, and citizens are expecting more. Only the government and central bank have the power to turn the tide.

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“Another shock, followed by more Fed action, may be needed for stocks to push higher”, said Barry Bannister, chief institutional equity strategist at Stifel ,“To coax the Fed to do ever more, we believe the market must first experience a deflationary shock, such as another yield curve inversion in the second quarter, to which the Fed would react.” The market is also calling for a new round of quantitative easing.

Hence, expanding the money supply to save business is inevitable even though it would harm its efficacy. We are in the vicious cycle and at the end of the cycle, it is the bottom of the liquidity trap.

Indeed, money printing brings monetary liquidity.

Why does the monetary liquidity not change to funding liquidity?

Besides the low investment returns, another reason is that investors lack confidence in the market. The health crisis as well as the economic recession have not gone yet. There is still an atmosphere of tension in the market.

Additionally, the adage “sell in May and go away” may double the tension in such a volatile environment. These change the liquidity preference and lead to consumers hoarding money.

More governors’ actions are expected to relieve the situation, but many states are bankrupt themselves and lack the capital to help their constituents.

Only when the monetary liquidity fully transforms to funding liquidity and ameliorates the low production rate, will the world pass through this downturn. A possible accelerator of this process is the breakthrough in the medical field to defeat the Coronavirus. If the disease is cured, global investors’ anxieties are addressed from the source.

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To avoid falling into the liquidity trap, more policies should be applied.

Luckily, the US Treasury is initiating loans of over 1 trillion dollars to small and middle-sized businesses.

Although it may not be enough, it would address the funding liquidity problem partially.

A small challenge is the potential of stagflation. Stagflation represents the combination of stagnation and inflation in the economy. Obviously, the inflation rate would increase as the money base grows stronger. But currently there is no inflation as people don’t have money to buy anything. We are seeing deflation in a number of areas.

The abnormal negative GDP in the first quarter(-4.8%) is the result of the staying home policy. Now with a high unemployment rate, the GDP may not perform as well after the stay at home orders end, which might see stagflation, though this is unlikely, more policies might be needed to address such problems.

Depression is probably more likely than stagflation.

If we have a depression mixed with a 0% yield in bonds will stocks be the only area for investors to hunt for yield?

In the short term, the market may not be very liquid since we are still undergoing this crisis. However, in the long term, with appropriate policies at appropriate times, the stock market would become attractive again.

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Written by Junping Chen, Edited by Michael Ding & Alexander Fleiss

Reference:

  1. Stéphane Lhuissier, et al. “Does the liquidity trap exist? ” April 08, 2020, BIS Working paper,https://www.bis.org/publ/work855.htm
  2. Sandy Kemper. “How to solve the $16 trillion small business liquidity trap. ” April 08, 2020, Startland News. https://www.startlandnews.com/2020/04/sandy-kemper-liquidity-trap/
  3. Thomas Heath “Wall Street powers through waves of bad economic news to its best month in decades.” April 30, 2020, The Washington Post, https://www.washingtonpost.com/business/2020/04/30/stocks-markets-today-coronavirus/
  4. Gillian Tett “US stock market rally confuses liquidity with solvency .” April 30, 2020, Financial Times,https://www.ft.com/content/cc31fe38-8adb-11ea-9dcb-fe6871f4145a
  5. William Watts. “Why a stock-market bull who nailed the April rally now refuses to lift his S&P 500 target.” May 01, 2020, Market Watch, https://www.marketwatch.com/story/this-stock-market-bull-called-the-relief-rally-that-took-the-sp-500-to-2950-but-now-hes-reluctant-to-raise-his-target-2020-04-30
  6. Mark DeCambre. “After the best April for the Dow and S&P 500 in 82 years, is ‘sell in May’ in the coronavirus era a smart strategy?” May 02, 2020, Market Watch,https://www.marketwatch.com/story/after-a-blockbuster-april-for-the-dow-and-sp-500-is-sell-in-may-in-the-coronavirus-era-a-smart-strategy-2020-04-30?mod=article_inline

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Alexander Fleiss

Alexander Fleiss

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Alexander Fleiss is the CEO of Rebellion Research, A Scientist, Teacher & Ai Researcher