28/02/2023 The risk rally that has run since October may be about to
hit a brick wall as liquidity starts to drain out of the global financial markets once more.
Quantitative tightening by the Fed has long been seen as a reason to be more risk averse,
but over the last three months there have been decent flows supporting equity markets.
However, that might about to change, as Citi’s Matt King points out that the reason for the
rally is down to some arcane liquidity-related central bank actions that are behind us. He
notes ‘obscure technicals’ relating to central bank liquidity, such as declines in
government deposits at the European Central Bank and reserves at the Bank of Japan and
People’s Bank of China, which has added a collective $1tn in additional liquidity since
October. In the US, a fall in the use of the Fed’s overnight reverse repurchase agreement
facility, as well as a decline in money held in the Treasury’s general account, has also
helped improve flows of cash into the banking system even as reserves fell. But all that
could be over now and the rest of the year is likely to see declining liquidity and, as a
result, fewer technical factors supportive of equity markets to rally further. “The origins
of this year’s risk rally lie in obscure technicals driving central bank liquidity,” says
King in the report. “At this point we think most of the boost to reserves is done. This
implies that the story for the rest of this year should return to being one of liquidity
drainage and risk weakness.” According to Citi, this is more than just a load of market
noise: the $1 trillion is worth about a 10% boost for stocks. As we noted in the Watchlist
2023, our preview to the year ahead in the markets, declining liquidity will present itself
as one of the most important causes of market volatility in the months ahead, particularly
as the Fed continues to raise nominal interest rates. The Fed’s quantitative tightening is
making low liquidity and high volatility in the $20-trillion US Treasury debt market worse.
It has moved from being the largest marginal buyer – around 40% of the market – to a net
seller. Certainly, liquidity problems have been brewing in the Treasury market for some
time, but there is a risk that the more QT is done the more acute these might become. The
Federal Reserve raised alarm bells last year, warning in its Financial Stability Report of
the systemic risks posed by declining liquidity. Such is the extent of the potential for
market volatility and dislocation, the Fed may be forced into halting the sale of Treasuries
and mortgage-backed securities (MBS) in order to shore up financial markets and prevent
instability in the crucial Treasury and overnight repo markets. That would result in a
significant ongoing liquidity injection but it remains to be seen whether the Fed would be
willing to risk inflation getting out of control again just to protect financial markets.
The Fed will be reluctant to stop QT: since a large chunk of the $5tn pandemic QE is
responsible for today’s inflation you must accept that shrinking the balance sheet is an
important tool alongside rate hikes to curb inflation. Stan Druckenmiller, the famed
investor, warned last year that all those factors that cause a bull market (mainly cheap
money + unlimited liquidity) are not only stopping but are reversing. That process has been
on pause since October, but the reversal looks set to begin again in earnest – unless the
Fed decides to step in.
Group