How Crashes Happen

While everybody is speculating on the impact of the Fed rate increase, think about this: the cost of money doesn’t matter.

Who cares whether it’s 0.00 or 0.25? Not that a rate increase can be sustained without removing liquidity from the system. We don’t know if the abracadabra method of raising rates will even work.

The quantity of money is what matters. And that is governed by, and a result of a very, very complex set of interactions. The central banks are not the only actors.

Banks, shadow banks, dealers and big trading firms all play a role. The markets themselves can create or destroy cash, just as the commodity and emerging markets and junk debt markets are doing now. If confidence is shaken, the markets can destroy liquidity with ruthless efficiency.

Another factor lately– the US Treasury withdrew $310 billion from the market in November, as it sold immense amounts of new debt to replenish its cash coffers after running them down to near zero while bumping against the debt ceiling.

That had an impact. It sucked cash out of dealer and institutional investor accounts as they paid for the new paper, and simultaneously bought enough in the market to keep prices elevated for a while.

But then they had to rebuild their cash levels. So, November began with the SPX at 2100. Six weeks later it hit 2000. Perhaps the dealer and institutional liquidation to rebuild cash has run its course, but while in progress prices took big hits in other markets as the reliquefication spread to junk debt, commodities, and emerging market equities.

That triggered margin calls, obliterating lots of trading capital. We can’t quantify that until well after the fact, if at all. But we see the news stories of runs on hedge funds and mutual funds and resulting shutdowns.  All of this stuff can suddenly snowball.

That’s how crashes happen.

Regards,

Lee Adler
for The Daily Reckoning

This article was originally posted at Wall Street Examiner, right here.

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