Liquidity and the rally

Good morning. Today’s consumer confidence report from the Conference Board will provide more grist for the debate over why consumers feel downbeat. Regular readers will know we think it comes down to price levels. Mostly, though, we are sick of talking about it. Email us about anything else: robert.armstrong@ft.com and ethan.wu@ft.com.

Is the RRP behind the rally?

Yesterday, we tried to make sense of the November rally, during which the S&P 500 has risen 11 per cent from its October lows. We put it in familiar, fundamental terms: investors believe we’ve seen the peak in rates, inflation is slowing, profits are rising, sentiment improving.

But there is another way to explain the stocks bounce: liquidity. After what we (wrongly!) thought looked like a fading US liquidity boom, liquidity is on the rise again. That uptick has coincided neatly with November’s stock rally (note the upward hooks at right):

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The blue line above focuses primarily on the changing size of the Fed’s balance sheet, net of other major factors that affect liquidity conditions. These include the Fed’s Bank Term Funding Program (an emergency facility which adds liquidity to the banking system), the Treasury general account (which captures how much liquidity is sitting inert in the Federal government’s bank accounts), and the reverse-repo window, or RRP (a Fed-controlled facility that sops up unwanted cash from the money markets).

Writing about how liquidity affects stock markets is treacherous because nearly all relationships are contested. Some argue the BTFP doesn’t matter, or that the details of Treasury department operations matter a lot, or that bond market trading conditions play a role, and so on. All these points are fair enough. At Unhedged, though, our bias is towards conceptual simplicity. So here is one dumb way to make the point. The reserves that commercial banks hold at the Fed (an easy measure of cash sloshing around in the financial system) tends to go up when stocks do. And both have gone up recently:

Remember why liquidity, in principle, should matter to stocks. The key is the “portfolio balance channel”, or what we’ve called the “hot potato problem”. Investors only want to hold a certain proportion of cash in their portfolio. As more cash finds its way into the financial system, the marginal investor has too much cash and wants to get rid of some of it. This increases demand for securities. But there isn’t an infinite universe of investable securities. So higher demand pushes stock and bond prices up, and pushes investors further out on the risk spectrum, until investors as a whole again feel they hold an appropriate amount of cash.

Liquidity alone does not determine asset prices. Sentiment is the other half of the picture: it determines how much cash investors as a group want in their portfolios. That is why the correlation between liquidity and risk asset prices is not perfect, and changes through time.

Two parts of the November rally fit with the liquidity story. First, some of the assets rallying hardest contain echoes of the 2021 bull market, when liquidity was also on the rise. Cathy Wood’s tech-focused Ark Innovation ETF is up 33 per cent this month; bitcoin is up 10 per cent (despite the most important crypto institution paying $4bn in money-laundering fines); and the Nasdaq has outperformed the S&P 500, on the back of the Big Techs. Second, fund flows are up across the board. Discretionary investors have driven several weeks of fresh inflows into stock, corporate bond, and money-market funds in the US, according to Parag Thatte’s team at Deutsche Bank. Fund flows aren’t everything, but new money entering various asset classes is what you’d expect if new cash was pouring into markets.

So if a liquidity-driven stock rally seems plausible, what explains rising liquidity? A big reason is rapidly falling balances at the reverse-repo window, as we wrote about earlier this month. In 2023, the RRP has declined from $2.3tn to just over $900bn, a 61 per cent decline, reintroducing previously unneeded cash back into the system. This was bound to happen eventually as quantitative tightening marched on, but its speed surprised us.

Why the RRP is declining is less obvious. Michael Howell of CrossBorder Capital argues the decisive factor is the US Treasury is issuing mostly short-term debt. Treasury bills of six-month duration or less are very appealing to money market funds, many of whom have had their assets parked, inert, in the RRP. The funds prefer the longer tenor of the bills over the RRP, which is an overnight facility. So money is coming out of the RRP and being handed to the federal government, which is spending it.

If the Treasury was selling long-dated bonds, Howell argues, the money to buy government debt would not be coming from out of cold storage in the RRP, releasing liquidity. It would instead absorb liquidity from elsewhere in the system. Furthermore, the lack of long bond issuance make long-duration assets scarce, pushing investors towards “duration substitutes” such as corporate bonds and equities, further supporting the rally.

Matt King, formerly Citi’s liquidity maven and now principal at Satori Insights, takes a different view. He says increased bill issuance matters, but not as much as an increase in traditional private repo activity. Unlike the RRP where investors stuff cash at the Fed to get a yield, old-fashioned repos are a method of secured borrowing. Importantly, they are a funding source for one leg of the popular Treasury basis trade, activity in which is at record levels. King thinks money market funds are taking cash from the RRP and lending it to repo borrowers, who may be hedge funds running the basis trade.

Whatever the reason, cash that was once dormant is being redeployed, which helps explain why markets are shrugging off some early signs of a slowdown. It’s hard for us to see this mini rally developing into a full-fledged bull market, but a good-enough balance of economic news plus a liquidity bump is keeping stocks happy for now. (Wu & Armstrong)

One good read

China’s mosques.

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