The U.S. stock market hasn’t found a reason to call it quits yet on the 2023 rally, despite a flood of Treasury debt issuance at plump yields which is helping to drain liquidity from financial markets.
The S&P 500 index
SPX,
was up about 19% on the year through Wednesday, while the Nasdaq Composite Index
COMP,
had shot 37% higher and the Dow
DJIA,
was up nearly 6%, according to FactSet data.
The rally in stocks wasn’t entirely expected, given the shock of the Federal Reserve’s interest rate hikes, the flood of investors into bonds and the liquidity drain in markets from heavy Treasury debt issuance to restock U.S. government coffers run low by the debt-ceiling fight.
But crypto
BTCUSD,
prices have been shooting higher too, along with a rally in the junk-bond market and shares of Carvana
CVNA,
and other debt-laden companies.
So what gives? BofA Global rates strategist Mark Cabana and Katie Craig have answers as to why the U.S. liquidity drain has not been affecting most financial markets as they have been explaining for weeks.
In short, money-market funds that once were part of $2 trillion invested via the Fed’s overnight reverse repo facility, instead have been allocating more of their cash to the deluge of new Treasury bill issuance.
“We long held an out-of-consensus view,” that the debt-limit resolution’s “liquidity drain would draw 90%” from the Fed overnight reverse repo facility (see chart), and 10% from reserves, the team wrote, in a Wednesday client note.
“We expect more of the same going forward, which should defer aggregate banking reserve scarcity until at least 2H’25.”
Use of the Fed’s overnight reverse facility lately has fallen to about $1.7 trillion, down from a peak of nearly $2.6 trillion in December, even as its 5.05% daily rate remains competitive with short-term bill yields.
The one-month Treasury bill yield
TMUBMUSD01M,
was at 5.28% on Wednesday, while the 6-month rate
TMUBMUSD06M,
was at 5.48%, according to FactSet.
“We have been surprised by only modest bill cheapening,” the BofA Global team wrote.
The team broke down the Fed’s “balance liquidity drain” since early June as: $469 billion from the Treasury’s rebuilt cash balance and $88 billion from balance sheet reduction.
In addition, the Fed’s policy interest rate currently was increased to a 5%-5.25% range, the highest since 2007, with another 25 basis-point hike expected next week. Overall, the Fed’s balance sheet also has contracted to about $8.3 trillion from a near $9 trillion peak.
The BofA Global team expects the liquidity drain to continue until there is a recession, market functioning issues crop up, or scarcity hits banking reserves.
Read: Why one analyst thinks possible recession could still arrive by February
Looking ahead, Cabana and Craig expect a $0 balance on the Fed’s overnight reverse repo facility by September 2025, a reduced Fed balance sheet to about $6.4 trillion and the end of quantitative tightening, or the policy of shrinking its balance sheet.
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