There was supposedly a liquidity cliff looming. The theory was – once the debt ceiling is resolved, treasury bill issuance will re-commence. The barrage of issuances would drain liquidity from markets. And that will result in a big drawdown in risk assets…
The US debt ceiling was resolved on 3rd Jun 2023. The Treasury General Account Balance around that date was US$44bn. It stands at US$514bn today!
Here is what risk assets have done in the interim:
S&P500 : +7.7%
Nasdaq Composite : +9.3%
So what really happened here in the context of liquidity. 2 things. First, just like the Fed planned, the Reverse Repo Facility came to the fore resulting in a lower drain of bank reserves. Second, the US government continued its spending binge. Lets look at both these factors in a bit more detail.
And then finally at the end, we will look at whether there was any statistical significance, in the first instance, to the theory of correlation between liquidity (aka bank reserves) and the broader market returns (i.e. S&P)
The Reverse Repo Facility
For the uninitiated, a Reverse Repo is a transaction where the Markets Operations Desk of the NY Fed sells securities to a counterparty subject to an agreement to repurchase the securities at a later date. You can think of this as a loan provided by market participants (primarily money market funds) to the Fed. It temporarily reduces the supply of reserve balances in the banking system. Theoretically, the US$2.5 trillion or so accumulated in the RRP at its peak in 2022 was surplus liquidity that the market did not need.
The build-up in the RRP facility in 2021 and 2022 to its highest level of approx. US$2.5Tn
When the Fed embarked on its Quantitative Tightening program in 2022, the key question on everyone’s mind was whether the draining of liquidity will come from these surplus balances in the RRP or will it come at the expense of bank reserves. The overarching concern about draining bank reserves beyond a certain level (in Fed lingo this is called “LCLOR” or “Lowest Comfortable Level of Reserves”) in Chairman Powell’s mind was influenced by the events of Sep 2019, infamously called the Repo Tantrum of 2019. In mid-September 2019 overnight money market rates spiked and exhibited significant volatility amid a large drop in bank reserves due to corporate tax payments and increases in treasury issuances. Those events had effectively led to the Fed shutting down its QT operations and re-starting QE. The question this time around was – Will history repeat itself?
Repo Meltdown in Sep 2021 attributable to reserves falling below acceptable levels
Chairman Powel must have breathed a sigh of relief given that this is the one thing that the Fed was been proved right on….. so far. As the US Treasury ramped up its bill issuance after the resolution of the debt ceiling, the RRP balance has come down by approx. US$440 billion from US$2.16 trillion to US$1.72 trillion. On the other hand, bank reserves have fallen only approx. US$70bn to a latest level of US$3.23 trillion, still significantly higher than the roughly US$2.2 to US$2.5 trillion or so that the Fed estimates to be LCLOR.
“We have the standing reverse repo facility and everyday firms are handing us over $2 trillion in liquidity they don’t need. They give us reserves, we give them securities. They don’t need the cash,” Waller said. “It sounds like you should be able to take $2 trillion out and nobody will miss it because they are already trying to give it back and get rid of it”Chris Waller at an event hosted by the Council on Foreign Relations in Jan 2023
RRP balances substantially lower in the last 45 days….
…but Bank Reserves have held up well.
There are only 2 ways of real money printing in our modern economic world. The first is through commercial bank lending. The second is through deficit spending. And unarguably the US is on a mission to outdo every other country and its own historical record on this account! Here are some bullet points to illustrate the message.
This is money squarely into the hands of the public…. the final consumer… in an economy which is 67% driven by domestic consumption. The deficit in the last 4 months alone has been US$670 bn compared to US$39 bn in same period last year. Medicare payments are on track to cross US$1 trillion for the first time. All this money gradually finds its way back into the banking system a.k.a Reserves!
Source: US Treasury
So while US monetary policy continues on a tightening path by raising interest rates and crimping bank credit, the overall liquidity scenario in markets has not deteriorated further from 2022.
Going back to the hypothesis
But does this explain the rally in risk assets in 2023. Like I mentioned at the start, a number of strategists were predicting a precipitous drop in equities with the draining of liquidity post resolution of the US debt ceiling. However, this correlation between US liquidity, as measured by bank reserves and the broader equity market i.e. S&P500 is extremely weak. I ran a regression on Change in Monthly Average Reserves and S&P 500 Monthly Returns. Below is the regression output. In simple words, the correlation coefficient between the 2 data sets was 22%. R Square, the Coefficient of Determination, which explains the relationship between the “y” variable (S&P returns) and “x” variable (change in reserves) was a mere 5%.
I also tried lagging the S&P returns by 1, 2 and 3 months to see if there was still a statistically significant relationship, albeit with a lag. No such luck!
Just to caveat, I am not making a case here to suggest that the S&P500 is going to scale new heights this year. Neither am I suggesting that liquidity does not matter for risk assets. In fact, I hold the view that risk assets are overbought right now and ripe for a correction. The bottom line though is that risk markets are driven by a multitude of fundamental factors and sometimes just pure sentiment and herd mentality. To overly rely on a single factor for determining market direction is a sub-optimal investment strategy.