It’s all about liquidity, honey (Macro Update)
Monthly Performance Summary for October 2022:
- USD Liquidity Index: up +2.5%
- S&P: up +8.0%
- Nasdaq: up +3.9%
- BTC: up +5.5%
- Rest of the crypto market (total excl. BTC and stablecoins): up +12.9%
This month, we are digging a bit more into the concept of financial market liquidity, the shortage of liquidity in the US Treasury market, and the anticipated Treasury Buybacks program that has likely fueled the market rally in crypto and equity during the last part of October.
It’s all about liquidity!
Put simply, the liquidity is the amount of dollar available to chase financial assets. Here is a great article from the Last Bear Standing that explains the mechanic in detail, let me TLDR’d it for you:
There are two key dynamics that drive the dollar liquidity in financial markets:
- The total supply of dollars from the FED, which correspond to the size of the FED’s balance sheet, currently standing at $8.7trn
- The internal composition of the FED’s balance sheet, which changes with the flows between the Treasury General Account (TGA, currently at ~$0.6trn), the Reverse Repo Facility (RRP, currently at ~$2.3trn) and the private financial markets (currently at ~$5.8trn)
- Quantitative Easing (QE) was increasing the total amount of dollars available in the system without changing the TGA or RRP = good for the financial markets
- Quantitative Tightening (QT) is now decreasing the total amount of dollar liquidity ($72.5bn net drop in FED balance sheet this month) = bad for the financial markets
- The TGA increase when the US Government issue new debt securities, which sucks liquidity out of the markets = bad for the financial markets
- The TGA decrease when the US Government spend his money (e.g. to pay public sector employees, private contractors, buy equipment, etc.), this liquidity returns to the private markets ($55.0bn net decrease in TGA this month) = good for the financial markets
- The RRP is an overnight fixed-rate facility available for Commercial Banks and Money Market Funds; in theory, if overnight rates in the private market are lower than the interest rate on the RRP, then market participants allocate more dollars towards the RRP, which reduces private market liquidity = bad for the financial markets
- Conversely, if private interest rates are higher than the RRP rate set by the FED, then money should flow out of the RRP and back into private markets ($150.5bn net decrease in RRP this month) = good for the financial markets
- The Financial Market Liquidity is the remaining amount of dollars available to buy financial assets in the private markets (“private” as opposed to sitting at the FED in the TGA or the RRP):
USD Financial Market Liquidity Index = Total FED’s Balance Sheet — RRP balance — TGA balance
- There are a few other pockets that can impact the financial market liquidity (e.g. the Standing Repo Facility and the Central Bank Liquidity Swap lines), but those are marginal at the moment so I will ignore them
- If you are interested in monitoring liquidity in TradingView, I have created an indicator to track it
Liquidity is probably the most important factor that influence financial asset prices. Whether it is equity or crypto, there is a high correlation between liquidity and price:
Between December 2019 and November 2021, as emergency money printing from Central Banks (QE) was flooding the markets, we had the fastest expansion of USD liquidity ever recorded in modern history, growing from $3.7trn to $7.0trn (1.9x in 23 months). The same pattern was observed in other part of the world with the ECB, the BOJ, the BoE and the PBoC also expanding aggressively their balance sheets. This explains the total disconnection between the real economy and the financial markets during the Covid crisis in 2020–2021, with markets reaching new all-time highs while the real economy was in pause, with people locked at home for months, consuming less, many losing their jobs, and global GDP dropping by 3.3% in 2020.
The direction of travel has inverted since the beginning of the year with liquidity shrinking from the $7.0trn high in Nov-21 to $5.8trn in Oct-22 and financial assets following the same trajectory. However, we saw this trend starting to reverse again towards the end of last month, mostly driven by a $150bn decrease in the RRP which, together with a $55bn decreased in the TGA, more than offset the $72.5bn of QT. We had another positive net liquidity flow in July (+$160bn) which coincided with a strong bounce in the markets, but that one was mostly driven by large US Government expenses ($154bn drop in TGA) which is not really sustainable as the TGA balance tend to remain relatively stable within the $200–600bn range. With the ~$2.3trn RRP taking the central stage however, there is ample room for more liquidity expansion, and US Treasury Secretary Janet Yellen hinted in that direction.
What is happening in the US Treasury market?
The US Treasury market (outstanding debt instruments issued by the US Government, called Bills, Notes or Bonds depending on the maturity) is a huge market standing at a total value of ~$26trn. US Treasury debt securities are used all across the financial system in the US and abroad: that’s where commercial banks, pension funds, insurance companies, foreign governments, etc. store a large part of their capital (sometime via the use of intermediaries called Money Market Funds); they are also the most common form of liquid collateral used across the financial system. A functioning US Treasury market is paramount to the good functioning of the global financial markets.
By aggressively raising interest rates, the FED has made it somewhat less attractive for financial institutions to buy debt securities, because when rates increase, price of debt securities on the secondary market fall, and if you know rates are going to continue to increase, why would you buy today? Especially when you have a risk-free alternative (which you do if you are a Money Market Fund or a Commercial Bank) that is parking your money in the RRP at the FED and getting paid 3.05% APR currently.
In addition, since the 2008 financial crisis, the banks that act as market-makers for those securities are burdened by the Supplementary Leverage Ratio (SLR) which requires them to set aside capital against such activity. So, market-making in US Treasuries is a capital-intensive business, which makes it not so attractive for those institutions.
This has resulted in a shortage of liquidity in the US Treasury market with market depth getting close to level not seen since the 2008 GFC or the 2020 Covid crash, which causes some serious concern to the US Treasury Department, forcing them to come up with a plan.
The Treasury Buybacks Plan
To mitigate the US Treasury liquidity shortage, the US Treasury Secretary Janet Yellen mentioned that they are considering conducting a buyback program where the Treasury would issue new debt securities and use the proceeds to buy back older securities.
The securities being newly issued would be short-term (i.e. Treasury Bills) and will have to offer a more attractive rate than the current RRP rate. This should incentivize Money Market Funds to reallocate part of their cash currently sitting in the RRP to buy those newly issued T-bills, which will move money from the RRP to the TGA. The US Treasury Department would then use this capital to buy back longer-dated securities (e.g. Treasury bonds) from the private market, therefore moving money out of the TGA and increasing the financial market liquidity. This would be mechanically equivalent to QE and should benefit risk assets (to understand why, you can check this article detailing the mechanics).
Needless to say that this policy is unproven and there are many thing that could go wrong, or backfire, including:
- This is in direct contradiction to what the FED is trying to achieve by tightening financial conditions to curb inflation
- If the offered premium on new US Treasury issuance is not high enough, Money Market Funds might not be willing to play that game and take on the additional level of risk that comes with holding US Treasury vs. RRP
- This will increase funding cost of the US Government while lowering the weighted average maturity of its debt and making its interest burden more sensitive to changes in FED rates (Net Interest expenses is already expected to represent 8% ($475bn) of the US Government spending in 2022, before the enactment of this new policy… a reminder that high interest rates are not sustainable given the amount of debt outstanding and the structural deficit)
Such buyback program is easier for politicians and the Fed to push (e.g. instead of the FED reversing QT and starting to buy bonds again with newly printed money), as it would be seen as having a net zero effect on the Fed’s battle against inflation, so it’s likely to move forward. If enacted and successful, this should enable a more sustained move for risk assets in the next few months (you can track how things evolve by watching the liquidity Indicator in TradingView). We should still expect some downside volatility as real-world economy contracts, impacting employment, growth, and earnings, but this would surely alleviate the pain… for people who own financial assets, and widen the wealth gap for the ones who don’t.
