The bear market is caused by a sharp contraction of the money supply due to liquidity withdrawal by the Central Bank. Even more, damage can be (and will be) done by the U.S. Federal Reserve.
- The QT is scheduled to start in June, but the Fed is already hinting at a tightening (outflow) of liquidity within a few months.
- The Fed’s effective balance sheet should shrink by $2 trillion under the QT plans, but a policy error could easily lead to a larger $3 trillion correction and bring down stock prices.
Since late 2021, the market has been bearish on global risk markets, based on a perceived decline in global liquidity.
After stock prices have fallen nearly 20%, many believe or hope that things will not get worse. However, this is likely not the case.
Quantitative easing (QT) in the U.S. is due to begin this month, but already we are seeing $1 trillion out of the money markets. More will likely be withdrawn in the coming months.
Moreover, given the terrible inflation data for May (the highest since 1982 at 5.4%), it seems more likely that the Fed will try to “postpone” the planned tightening until the second half of 2022.
Full conclusions from the photo above.
The market has followed the Fed’s liquidity operations closely in recent years, and the time lag seems to be getting shorter and shorter.
When comparing the “effective” balance sheet data with the published size of the balance sheet, it becomes apparent that it is the former that really matters. In short, the market’s focus on the unofficial balance sheet size is misplaced.
Certainly, QT will matter, but there are many other things going on. The chart shows that the U.S. Fed has already extracted $1 trillion from the money markets, even before the QT officially begins.
Before understanding the dynamics, let’s look at the impact of dollar liquidity withdrawals per unit. Each $1 trillion in liquidity withdrawn reduces the S&P500 by about 500-600 index points or about 12%.
In other words, a 15% reduction in liquidity means a similar drop in asset prices. Interestingly, the wait time for Fed action has fallen sharply from an average of 14 weeks over the entire period to 1-2 weeks recently, suggesting that lack of liquidity is becoming a critical problem.
The outflow is also evidenced by the 67% reduction in liquidity on the mini-SPX contract compared to 2017-19.
The bar chart above shows the projected volume of U.S. Federal Reserve Treasuries in the Systematic Open Market Account (SOMA) through 2025 and the estimated effect on bank reserves, as estimated by the New York Fed.
Both figures should fall by about 30-35%, which should be a benchmark for investors to judge the likely decline in the market. If we take the first chart and calculations on it as well, we can assume that this policy will lead to a decrease in liquidity injections of another $1-1.5 trillion. This tells us that the target for the S&P500 will be 3,200.
But the situation may worsen due to other factors affecting the Fed’s monetary operations.
- Repurchase Repos (RRPs)- removes money market liquidity. They have recently grown to $2.4 trillion from about $670 billion a year ago, in part because the U.S. Treasury has cut back on promissory notes and money market funds have entered the Fed’s reverse repos as an alternative. These securities are essentially one-day cash holdings on the balance sheet of the Fed, backed by U.S. government assets and paying a relatively high-interest rate.
- To put this in perspective, the U.S. Treasury has already reduced its planned issuance of bills by $600 billion, which is highly likely to leak equivalent cash into the Fed’s RCB. In addition, the more aggressively the Fed raises rates, the more likely it is that money market rates will outpace bank deposit rates, thereby forcing deposits out of banks into money market funds. This could lead to an even bigger jump in RRPs. We can think of this as an unintended consequence of the Fed’s policy tightening.
If we add this additional, $1 trillion in RRP to the already planned $2 trillion QT, it could result in the Fed’s net liquidity injections dipping below $3.5 trillion.
This low level of cash corresponds to the S&P500 around 2500.