As I walked around Stanford yesterday, we came upon Lake Lagunita. This is an artificial lake on campus that was originally created to irrigate the stock farms on campus in the 1800s.

It subsequently became a nexus for campus social life, with canoe races and other events centered on the lake that has about a 1 mile circumference.

In the early 2000s, though, the university stopped filling it and given the drought California has been going through, it has been a dry bed the other times we have come to visit.

Given the heavy rains this spring, though, it is flush with liquidity, it appeared to be approximately 15 feet deep in parts, restored to is full glory from the early years of campus.

In the past few days, the banking system has also undergone a radical change in liquidity. What was a dry bed with banks having to sell HQLA to appease depositors, now is deeply liquid as banks can get what they need at the discount window

The discount window used to come with a negative stigma of only stressed banks accessing it. This change in 2008 as banks used it freely to get thru the crisis. Now, when there are stresses, the banks will use it.

However, the market can sniff out these stresses and we see bank stocks start to lag the overall market up until the banks getting the liquidity again.

We can see in the top chart that once the banks tapped the window in 2020, the performance turned around. We know in that situation, it worked out fine and the market also rallied with banks leading.

In the bottom chart, we can see the same action in 2008. The exception here is that while the banks tapped the window, the damage was done and the reason the banks outperformed was because other stocks fell faster with the economy seized up.

Right now we are seeing a sharp underperformance of banks yet we are barely seeing any banks going to the discount window. We can see the amount withdrawn is orders of magnitude less than the Covid period, which itself was far less than half of the 2008 number.

The market is sensing something here though. Which scenario will play out? Will the market rally led by the banks because the system is now liquid?

Or will the rest of the market roll over because capital is dear and the banks, while getting liquid, are going to make capital less available for the other companies in the economy. The Fed has made bank liquid but that doesn't mean the banks need to lend.

There are signs around Lake Lagunita, warning the students of the dangers of using the lake as a recreational area. There is a fence up surrounding it so there won't be any canoe races like the early days on campus.

There are no warning signs at the Fed discount window, but the banks have been here before. The banks know how loan portfolios may be changing and not for the better. The banks are likely to be a little more conservative until this plays out a little more.

Stay Vigilant

#markets #investing #liquidity #economy