by Jim Rickards, Daily Reckoning:

Liquidity is the ultimate paradox in finance. It’s always there when you don’t need it and never there when you need it most. The reason is crowd behavior, or what mathematicians call hypersynchronicity (a fancy word for everyone doing the same thing at the same time).

When markets are calm, no one wants liquidity because investors are happy to hold stocks, bonds, currencies, commodities and other assets in their portfolios. As a result, there’s plenty of liquidity on offer from bank lenders and very few takers.

The opposite is true.

In a financial crisis, everyone wants his money back at once. Stocks are crashing, bonds are crashing, margin calls are streaming in and everyone is trying to sell everything at once to avoid losses, meet margin calls and preserve wealth.

In those circumstances, there’s not enough liquidity to go around. Banks, and ultimately regulators, decide who lives and who dies (financially speaking) by offering liquidity or cutting it off.

Investors are lulled into complacency by the illusion of liquidity in good times. Investors know that markets turn around, that bulls become bears and that the time may come when they want to take some chips off the table and move to the sidelines.

Their mistake is believing that a willing buyer or bank lender will be there for them the moment they want to sell or finance a position. If an investor unwinds a position slowly enough and early enough, liquidity may be available. But investors who stay too long at the party discover that when they want to make a move to reduce position size, everyone else is doing the same thing and the crash has already started.

That’s one of the hardest parts of investing: deciding to liquidate positions when markets are still rising and the party is still going strong. Investors are overcome with FOMO (fear of missing out). They don’t want to reduce stock positions and obtain cash only to find their neighbor is still fully invested and enjoying big gains.

The obvious question for investors is whether it’s possible to get an “early warning” or predictive analytic signal that a liquidity crunch is on the way. If such a signal were available, it might be possible to stay a little longer at the party to pick up market gains but still get out in time before the lights go out.

Right now, indications are that liquidity is growing scarce and it may be time to sell stocks and increase cash allocations.

The first is shown in Chart 1 below. The bar graph in Chart 1 shows participation at U.S. Treasury auctions over the past 10 years broken out by type of participant.

The most important participants are shown in blue. These are the dealers and brokers, consisting mainly of “primary dealers” who are obliged by the Fed to bid at auctions and make two-way markets in U.S. government securities.

The primary dealers are a leading source of liquidity in the Treasury market second only to the Fed itself. Primary dealers are required to be buyers when everyone is selling and to sell securities when everyone else wants to buy in order to maintain liquid orderly markets.

As you can see, overall participation has declined sharply since 2017 in all categories, and dealer participation has steadily eroded since 2012. Just as the Treasury has to sell record volumes of debt because of the Trump tax cuts and budget sequester repeal, the primary underwriters of that debt are backing away from the market, as are other market participants. The result is sharply falling liquidity in the world’s most important securities market.

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