Dom’s Quick Take: Liquidity Still Unlikely to Hinder Market Rally

A month ago, I argued that the TGA rebuild would not impede the equity rally. I have been right so far, though I overestimated the decline in reserves. My mistake is consistent with the recent decline in the FFR, a sign of abundant liquidity.

Reserves scarcity may not happen for some time: reserves are currently $3.2tn, and I only expect signs of scarcity to emerge after reserves fall below $3tn. Given how slow QT is (on average, less than $20bn a month since June 2022), reserves scarcity could still be many months away.

The decoupling of equities and reserves started in Q4 2022 and continued through June (Chart 1). I think this reflects that the same drivers – strong growth, stable inflation and a dovish Fed as well as a contained banking crisis – are supporting higher equity valuations but lower reserves.

By contrast, my predictions on the Fed balance sheet were off, with TGA increasing by much more and reserves decreasing by less than I expected (Table 1).

I also did not expect the (so far transitory) 1bp drop in the effective FFR, which is consistent with the much smaller decline in reserves than I expected.

The decline in the FFR likely reflects that, relative to banks assets, reserves have recovered above the level where, in 2018, the spread of the FFR over IOR started to increase – a sign of reserves scarcity then (Chart 3). 

This time, the recovery in the reserves to banks’ assets ratio is mainly explained by two factors.

First, paradoxically, the banking crisis has added to reserves availability. The Fed has created a new facility, the Bank Term Funding Facility, that has been growing steadily. By allowing banks to obtain funding with zero haircut, the facility has in effect removed interest rate risks on banks’ bond holdings and helped stabilize the banking system. This could explain the lack of stress in the interbank market: lending volume has recovered since the SVB failure, and spreads have been stable (Chart 4).

Second, due to QT and weak credit demand, banks assets have stopped growing since Q4 2022.

If banks’ assets remain flat, signs of reserves scarcity could emerge once reserves fall below $3tn, which compares with actual reserves of $3.2tn currently. But it could take a while for the Fed to get to scarcity as in practice QT has proceeded much more slowly than announced in June 2022 (Chart 5).  Over the past three months, for instance, the Fed securities portfolio has declined at a $12bn average monthly clip. Since the start of QT in June 2022, the average monthly decline in the securities portfolio has been $19bn, against caps of $95bn. This reflects the long duration of MBS but also, as far as Treasuries securities are concerned, a Fed eager to proceed cautiously.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

Photo Credit: depositphotos.com

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