The internal mechanics of the financial system have been the subject of extended essays in this forum over the last eighteen years. The first installment addressed an oddity, a quirk, a geeky curiosity among bankers, really that occurred between August 2 and August 9 of 2007.
Financial Markets Running on EmptyAt that time, the Fed had used its lender of last resort mechanism to inject over $38 billion dollars of cash over multiple days as inter-bank lending ground to a halt with absolutely nothing going on in the markets. Yet, the amounts of cash being injected by the Federal Reserve for a non-event actually exceeded the amounts required to stabilize markets after the September 11, 2001 attacks closed markets for three market days and were going to re-open with six days of cumulative uncertainty.
It turned out there WAS something going on in the markets as savvy institutions began sniffing out other overextended institutions and began understanding the implications of the derivatives market. The ripple from that first August 2007 pebble of worry rippled around the world economy, amplifying until a wave hit Bear Sterns which triggered a massive bailout which triggered more worry until an even larger wave capsized Lehman Brothers in September 2008 and kicked off the much larger global crisis.
The next story in this series arrived In March of 2023, driven by four different bank failures and a new round of overnight lending that even exceeded 2008 financial crisis levels in inflation-adjusted terms.
Do You Smell Smoke?Silicon Valley Bank failed due to its lack of diversification in assets, high share of accounts with balances far above FDIC insurance limits (hundreds of accounts holding MILLIONS of dollars above the $250,000 FDIC insurance limit) and a large number of business customers using it for payroll who suddenly had to pay billions in severance as their businesses slowed or failed. The firm could not support the cash drain imposed and required rescue. At the same time, two other banks Silvergate and Signature Bank failed in large part due to exposure in crypto markets then a third large regional bank named First Republic with the exact same symptom as Silicon Valley Bank – over 68% of accounts had balances exceeding the FDIC insurance limit. Markets pounced, First Republic stock tanked and an emergency $38 billion merger deal was hastily concocted and approved.
But at the same time of those four bank failures, the statistics behind daily operations at the Federal Reserve again showed a much larger looming danger. Again, the dollar value of overnight lending between March 10 and March 17 of 2023 SKYROCKETED to levels not even seen during the 2008 global financial crisis. Overnight lending from the Fed to member banks reached a total balance of $152 billion.
The liquidity theme again arose in April of 2025 as the Trump Regime vacillated on nearly an hourly basis over multiple days about the timing and level of threatened tariffs on billions of dollars in imported goods.
The Crash That Wasn't… YetAs markets reacted in elation then fear then elation ad nauseam, every swing in the markets created the risk of surprises in bets on interest rates. As Trump mouthed off at a fundraising dinner on April 7, 2025 about how foreign countries were lining up to kiss his ass, world traders began liquidating vast quantities of short term Treasuries. Treasury and Fed officials spotted this pattern that evening of April 7 prior to Wednesday morning market open and had convinced the Trump Regime to defer implementation dates on ALL tariffs to avoid triggering a lockup that would have rippled through derivatives markets and likely triggered a stock and bond collapse worldwide.
Finally, news from the week of August 10, 2025 served to further highlight the disdain with which banks and investors were beginning to view Treasury securities in particular and the Treasury's overall strategy in general.
Foreshadowing in the Bond MarketThe Treasury issued $95 billion in 4-week bonds on July 31 and another $100 billion in 4-week bonds on August 7. Statistics on those sales reflected a sharp contraction in the number of bidders participating in those auctions (signaling drastically reduced desire in participating in the auction) and the final price set for the debt at auction reflecting a growing gap between the Treasury's perception of appropriate rates and that of the larger market – with the market expecting HIGHER rates, not LOWER rates.
So why is this topic coming up again, only four days later? Because more ominous statistics are being seen regarding daily operations of the Federal Reserve and the larger market, all of which again point to a sharpening contraction in liquidity.
The Takeaway
If nothing else in this analysis clicks with readers, this general thesis first summarized this way in the Crash That Wasn't...Yet piece is the most crucial lesson to learn and apply to future events.Bad things in the economy don’t happen when investors lose money. Investors lose money every day. Bad things -- REALLY bad things -- happen when money stops flowing.
Money stops flowing when parties to a proposed transaction feel unable to determine the level of risk they are taking in entering a deal with each other. That risk stems from multiple factors:
- the ability of the party paying money to deliver the promised amount
- the ability of the party receiving money to deliver the promised good or service being purchased
- concerns of either party of the actual stability of the currency used as the medium of exchange
- concerns of either party regarding larger systemic risks in the economy that might make the transaction impossible to complete or entirely moot
If nothing else in markets is making sense, any collection of signs that reflect a contraction in the liquidity of the markets is the biggest danger sign to watch. A faulty engine can still move an economy in a good or bad direction but keeping the engine turning is critical to correcting any other input. An engine that has seized cannot take the economy ANYWHERE. The key is to watch for news related to internal market liquidity, not the frothy stuff about which stocks are up or down or what interest rates are.
So what's the danger sign emerging the week of August 10?
Running On Empty – Redux Times Five
On August 14, 2025, previous concerns about market liquidity as reflected in participation and pricing in Treasury auctions over the prior two weeks was reinforced by new statistics on the dollar value of reverse repurchase contracts between the Federal Reserve and member banks. As a brief explainer (or reminder), the Federal Reserve uses two mechanisms to influence the amount of cash within the larger economy. At the same time these tools manipulate cash within the banking system, they also allow the Fed to try to influence interest rates.
A repurchase agreement involves the Federal Reserve buying securities from banks and giving cash to the bankin return. This pushes cash INTO the banks and the larger economy, often when the banks need it for short term crunches. At the same time, in order to convince the Federal Reserve to surrender the cash, the borrowing bank is agreeing to a higher interest rate premium to reflect the degree they NEED the cash. As a result, repurchase agreements tend to drive interest rates UP.
A reverse repurchase agreement sells securities off the Federal Reserve's balance sheet to banks and takes in cash while promising to buy that same security a few days in the future at a higher price. In the short term, this pulls cash OUT of banks and the larger economy. Because the Fed is agreeing to buy that security at a higher price, this acts to reduce interest rates.
In normal market scenarios, regardless of the actual level of inflation, interest rates, stock prices, the phase of the moon, etc. when all market forces are in general agreement about the absolute level of risk in the market, these re-purchase and reverse re-purchases agreements take place every day with magnitudes in the tens of billions of dollars range. That's normal. Within these norms, the overall system provides enough wiggle room for the Federal Reserve to use these "knobs" every day and apply the SLIGHTEST of nudges to interest rates to keep things approximately where the Federal Reserve thinks they should be. But this mechanism only works when it's invisible and NORMAL daily operations are driving these incremental repo and reverse repo volumes. When risk perceptions in the larger market change overnight and demand for the types of securities used to fuel these repo and reverse repo transactions spikes UP or DOWN, the mechanism cannot be relied upon. The magic doesn't work if everyone sees the magician trying to turn the levers where they weren't designed to go.
In the week of August 10, 2025, the volume of reverse repurchase agreements dropped precipitously. Going back to first principles, the Federal Reserve would be trying to USE reverse repurchase agreements to drive UP Treasury prices which drive DOWN short term interest rates. Keep in mind that's what the Trump Regime and its Treasury are betting on. They're betting $100 billion dollars a week on this eventuality.
But for the Fed to begin triggering higher volumes of reverse repurchases, there have to be banks willing to HOLD existing short term Treasuries and those banks have to believe that short term interest rates CAN come down and drive those Treasury prices UP. The Treasury auction results from the week of August 3, 2025 point out that fewer banks are buying up short term Treasuries so assumption #1 involving existing holdings is weaker than it was months ago.
Those same banks have less confidence that interest rates CAN go down because the Producer Price Index (PPI) inflation report was released August 14 that showed inflation within the producer sphere of the economy jumped 0.9 percent in July of 2025. Going back for the past twelve months from August 2024 through July 2025, that PPI index has accumulated to an increase of 3.3%. But that's looking backward over twelve months where higher tariffs were not part of expectations except for the most recent five months. That July 2025 monthly rate of 0.9 percent inflation would equate to 11.23 percent if it held steady for the next twelve months. That's DEFINITELY not compatible with the Federal Reserve LOWERING interest rates to appease the Trump Regime.
Finally, banks and the larger markets are also becoming concerned because at the same time the Treasury has been stating its intention to shift more of the government's existing debt into shorter term securities – expecting lower short term interest rates to lower borrowing costs – the Treasury has also stated it wants to increase the level of cash in what is termed the Treasury General Account (TGA). This essentially acts as the Treasury's checking account. The need for more cash in this account makes sense. If your personal finances rely on you rolling over payday lending loans, car loans, home equity loans and re-financing your 30-year ARM mortgage on your home every three days, you need a lot more cash on hand to accommodate these different sized loans coming up and needing to be paid off in cash while getting new cash from new loans.
The problem is that raising cash in the TGA account requires selling even MORE short term debt, beyond the "structural" short term debt being re-re-re-re-financed. The market is not liking this additional demand for borrowing and the Treasury is trying to raise the TGA balance from the current $504 billion up to at least $700 billion. To better grasp the implication, imagine you are a current Treasury bill owner and you see your borrower, the Treasury, is borrowing even MORE money from MORE people to raise MORE cash so they can roll over even MORE of your current loans every week for the next ten years. That does not likely raise your confidence in the long term financial strength of your borrower. Do you keep lending? Or do you look for other places to lend money and earn a safer return?
Again, the net-net of all of this?
Even if the Federal Reserve WANTS to lower interest rates either because it agrees with the Trump Regime or simply wants to placate it, the Federal Reserve cannot literally dictate interest rate levels that no one else in the financial system buys. (Literally). The Federal Reserve's power to set interest rates is completely restricted by the willingness of banks to come running with cash when the Fed wants to sell Treasuries. If demand for Treasuries shrinks even five or ten percent, none of the levers on the Federal Reserve's machine work. The real concern is that they not only fail to work as intended for the Fed's tactical interest, they will fail to work under more dire emergency scenarios, like another financial crisis, a natural disaster, terrorist attack destroying hundreds of billions of infrastructure or another unfunded trillion dollar war.
It's a good thing these are all hypotheticals.
WTH
