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Treacherous Markets Ahead!

If you are an investor in the stock market, you may be in for a wild ride during the rest of this year. Think ROLLERCOASTER: slowly up, up, up, up and then, whoosh, way down fast. And, then, up again. Here’s why.

Liquidity determines the direction of asset prices; and the level of liquidity in the markets is going to change abruptly between the second and third quarter of this year. According to my calculations, liquidity will shift from being abundant – even excessive – in the second quarter to being tight in the third quarter and, then, very tight in the fourth quarter. This sudden change in liquidity conditions could whipsaw the markets.

The Fed has begun tapering Quantitative Easing. Nevertheless, it still intends to create $145 billion new dollars during the second quarter. It will inject that liquidity into the markets by acquiring financial assets. On the other side, the government is unlikely to absorb any liquidity at all during that period. Americans pay their taxes in April. Therefore, the US Treasury will probably have all the cash it needs and won’t have to sell any new (liquidity-absorbing) bonds during the second quarter. That’s going to leave a lot of excess liquidity sloshing around the financial markets between now and the end of June. And, when there is excess liquidity, stock prices tend to rise.

By the third quarter, it will be a different story, however. The Fed will print much less and the government will borrow much more. During those three months, the Fed intends to create only $85 billion, whereas the government could have to borrow $180 billion or more. With the government borrowing more than the Fed is printing, there will no longer be any excess liquidity. In fact, there will be a liquidity drain. The markets have been spoiled by a great deal of excess liquidity since the end of 2012 when the Fed launched QE 3. They are going to find the reduction in liquidity very unpleasant. Bond yields are likely to begin moving up and stock prices are likely to begin moving down. It is in such moments that stock market panics often take hold.

If investors do manage to maintain their nerve throughout the third quarter, they may find it considerably more difficult to remain calm during the fourth. The Fed has signaled that it will only print $20 billion during those three months, while the government is likely to have to borrow something like $240 billion to fund its budget deficit. (The budget deficit tends to be highest during the fourth quarter.) With the government sucking out much more liquidity than the Fed is pumping in, liquidity will be drained from the markets. In that environment, bond yields will rise. That will push up the cost of mortgages, causing the property market to take a hit. All this would be too much for the stock market to bear. If share prices don’t fall in Q3, then, in the scenario being described here, they seem very likely to fall in Q4. Falling home prices and stock prices would cause a big drop in household sector wealth. Consumption would decline and the US would tumble back into recession, pulling the rest of the world down with it.

I write “would” instead of “will” because I don’t believe the Fed will allow that scenario to play out. The Fed has worked very hard to push up asset prices in order to make the economy grow. I don’t believe they will allow liquidity to tighten to the point where asset prices tumble again and drag the economy back into recession. That means that sometime during the third quarter, if not before, the Fed is going to have to announce it will stop tapering QE. That announcement may prove to be the biggest financial news story of the year.

If I am right about this, then stocks are likely to move higher – and perhaps significantly higher – between now and mid-year. They will then begin to correct – and, again, perhaps quite significantly - during the third quarter. At that point, the Fed will ride to the rescue by announcing that it will continue its program of Quantitative Easing on into the indefinite future. Stocks will rally again on that news.

This rollercoaster scenario is the one that strikes me as the most likely as of now. Of course, the future’s not ours to see. Things change unexpectedly. Big disruptions appear out of nowhere. So, we’ll have to wait and see. However, given what we know now, it looks to me that liquidity is going to tighten substantially. That suggests that either the stock market is going to buckle or, more probably, the Fed will backtrack again and keep its printing presses working overtime.

For a full explanation of how liquidity drives asset prices, see my video-newsletter, Macro Watch. For a 50% discount, click on the link below and subscribe using the coupon code: richdad

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