The fading liquidity boom

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Good morning. However sticky US inflation might be, one glance at UK prices sure makes Jay Powell’s job seem easy. The Bank of England raised rates 50 basis points yesterday after an alarming inflation report that reeked of a wage-price spiral. We’ve got nothing to add beyond what our colleague Chris Giles has expertly written, but if you do, email us: [email protected] and [email protected].

Is liquidity behind the rally?

On Monday we sketched the arguments for and against declaring a new bull market. Some readers noticed that liquidity was left out. Fair point. For those who believe that liquidity drives speculative positioning, the signs of excess are seemingly everywhere. Bitcoin is back near $30,000, Cathie Wood’s long-shot tech exchange-traded fund is surging and the Nasdaq has risen 30 per cent this year, against 14 per cent for the S&P 500.

Earlier this month, we wrote that a liquidity crunch probably wouldn’t create a bank crisis, but could well punch risk assets in the face. We cited two scary-looking liquidity drainers:

• The $95bn-a-month drumbeat of quantitative tightening proceeds apace. The Federal Reserve lets securities on its balance sheet expire, and declines to reinvest the proceeds. This saps liquidity.

• With the debt ceiling resolved, the Treasury department must replenish its checking account at the Fed, called the Treasury general account, or TGA. It does this by issuing new Treasury securities. As cash is paid to the Treasury, this also saps liquidity.

Two weeks on, no crunch yet. Part of the story we didn’t consider at the time is that countervailing forces are at play, blunting the hit from QT and the TGA. Among them:

• The Fed is doling out funding through facilities such as the Bank Term Funding Program, set up after the failure of Silicon Valley Bank. BTFP usage is still elevated, at $103bn. This probably injects liquidity, though there’s some debate about this (see below).

• The Fed’s reverse repo facility, or RRP, has dipped below $2tn. The RRP is best thought of as a bucket of dormant liquidity. Falling RRP balances mean that cash is being deployed elsewhere in the market — a liquidity injection.

So, on net, is liquidity being added or subtracted? That depends on your opinion of the BTFP. The conventional view is that the BTFP acts something like quantitative easing, putting cash into banks in return for securities held as collateral.

But Joseph Wang, the Fed Guy, thinks this misses a crucial distinction between QE and the BTFP. One feature of QE is that Treasuries held by investors are sucked up and replaced with bank deposits. The banks only act as middlemen. On the asset side of the balance sheet, they get reserves (ie, cash) at the Fed. On the liability side, banks gain new customer deposits. Investors have, in effect, swapped Treasuries for cash deposits, and some of those deposits will ultimately get put into the stock market (or into a dog-based cryptocurrency, or whatever).

But the BTFP, Wang argues, cuts out investors. It is strictly a two-way deal between banks and the Fed. Banks receive, on the asset side, reserves at the Fed and, on the liability side, an emergency loan from the central bank. Unlike QE-style monetary stimulus, cash is not ending up with investors. “Banks,” Wang adds, “are definitely not buying Microsoft or Nvidia.”

This point is disputed. Mike Wilson of Morgan Stanley argues in a recent note that the BTFP’s practical effects — stopping a big, sudden bank credit crunch — may matter more to stocks than the technicalities:

Another mistake we made back in March was to assume the Fed/FDIC bailout of depositors was not a form of monetary stimulus. At the time, we said it was not QE. While that is true from a technical aspect — ie the Fed/FDIC are not buying bonds, but rather lending money to banks temporarily — it did add liquidity to the system and allowed banks to continue operating and extending credit. And, while we didn’t treat it as QE, other investors may have disagreed with our conclusion and traded the markets as if it was QE. This could explain why inflows and sentiment have changed so dramatically over the past several months.

But whatever you think about the BTFP, it’s hard to argue that the Fed is unleashing a flood of liquidity. Rather, liquidity is flat or falling. The Fed’s two main liquidity facilities, the BTFP and discount window, together had $168bn outstanding at the peak in March. That’s now down to $106bn. Maybe you think the effect on liquidity is bigger (not least because the BTFP generously takes collateral at par value). But that has to be weighed against everything else taking up liquidity. In the background, QT is, and will keep, removing $95bn a month. Dan Clifton of Strategas calculates that the TGA has sucked up $305bn in cash, only partially offset by a $105bn drop in the RRP. The chart below sums up liquidity conditions and plots them against the S&P 500. The two have come apart lately:

We don’t think liquidity is a theory of everything for stock valuations. The liquidity-risk asset relationship, as we’ve argued, is time-variant. But it does matter often enough to consider. That a US liquidity bump supported the rally in the first quarter of the year makes sense. This is fading, though there may now be an offsetting boost from global liquidity. As Michael Howell of CrossBorder Capital points out, the Chinese and Japanese central banks are both in stimulus mode.

Yet as QT thrums along and the TGA expands, the liquidity headwind to stocks will grow, and the BTFP and RRP can only partly offset that. If US liquidity has been holding up the stock rally, it won’t for long. (Ethan Wu)

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