Lee AdlerThat’s right. It’s not the Fed any more. This ain’t the QE era. Non-subscribers, click here for access.
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The stock market has mounted a seemingly sustained rally despite the fact that the Fed continues to steadily withdraw money (aka liquidity) from the financial system. Non-subscribers, click here for access.
This is not the good old QE days when the Fed steadily pumped money into the system, and we knew that the market would always rise, except when the Fed paused its pumping. We saw a market hiccup under Janet Yellen’s balance sheet shrinkage program in 2018, but then Panic Jerry set new standards of QE pumping in 2019 and 2020. Non-subscribers, click here for access.
I thought that once the new QT started that the market would be mostly bearish, with occasional rallies. Uh huh. Not. Non-subscribers, click here for access.
I am reminded that in the pre QE days of blessed memory that we often had bull markets with the Fed managing balance sheet growth at a nominal pace of 2-5% per year, year in and year out. But even that is different from today when, yes Virginia, there really is a QT, and the Fed really is shrinking its balance sheet. Except when it isn’t. Non-subscribers, click here for access.
Alas, the world is not so simple any more. The system can, when investors and bankers are of a single mind, create ample liquidity on its own simply by self-expanding credit. Bankers can decide to offer more credit. Investors can decide to use it. Non-subscribers, click here for access.
Or if asset prices, in this case stock prices, start rising far enough for long enough, players at the stock tables can simply decide to do it on their own. That includes not just the big investors and traders at the tables, but also the dealers running the games. Everybody winks and gets in on the winning action. Prices rise. Rising collateral value means more margin is available. Traders borrow against it. And away we go. Non-subscribers, click here for access.
Today the market has an added bonus: massive T-bill issuance by the US Treasury. Here’s where things get perverse. I had expected, wrongly, that the enormous supply would put downward pressure on all asset prices as the market was forced to absorb the new T-bill supply that would come when the debt ceiling was lifted. But my analysis was faulty. Non-subscribers, click here for access.
Two things happened that I did not expect. Fortunately, the technical analysis (TA) that I do in tandem with the liquidity side told me a few months ago that it was time to get long stocks. So I followed the TA, while trying to guess at what the liquidity source would be. This was just the opposite of the way things worked under QE, when we knew exactly what the source was, how much was coming and when. The TA naturally followed. Non-subscribers, click here for access.
The first thing that happened is that the big hedge funds hedged away the likelihood that Treasury note and bond prices would fall when the wave of new supply was released onto the market. So far that hedge has worked, by preventing bond prices from falling. I do not think that hedge will work indefinitely, but for now it is, and that’s all they needed to continue speculating on the long side in stocks. Non-subscribers, click here for access.
The second thing that happened, which I neglected to consider in my initial analysis of what would happen when the debt ceiling was lifted, is that T-bills are perfect collateral. They can instantly be used as collateral for repos — repurchase agreements (RPs) – which are very short term loans from banks or the Fed for nearly 100% of the face value of the T-bills. And use it, they have. Non-subscribers, click here for access.
At the same time, money market funds had over $2.3 trillion sitting in the Fed’s Reverse Repo (RRP) slush fund back in April. The Fed’s RRP program takes in excess cash from dealers, banks, and particularly money market funds. I had long noted that it would be used at some point to fund absorption of Treasury issuance and possible to support a rally in stocks. I had warned in these pages for the past year and a half that when the RRP started to decline, look out for stocks to rally. Non-subscribers, click here for access.
Voila, here we are. As of Monday, July 3, cash in the RRP slush fund had dropped from $2.275 trillion on May 22 to $1.909 trillion. That’s $356 billion in cash that came out of the RRPs to fund the absorption of the T-bill issuance. Those T-bills became collateral for an increase of private bank to dealer and bank to hedge fund RPs, instantly creating a massive amount of new credit for players to play with. And play they did. Non-subscribers, click here for access.
So here we are in a brave new world of automatic, self-created market finance, which will be indefinitely funded by the issuance of new Treasury securities. The tidal wave of $600 billion of new issuance in 2 months post debt ceiling suspension will slow after July. But we can still expect an average of $100 billion per month in issuance. And instead of new supply always pressuring the market, we must face the fact that the dealers and gamblers at the tables can, at will, increase the use of virtually automatic credit whenever they want to. The T-bills will provide the fodder. Non-subscribers, click here for access.
Is this system infinite and unbreakable? Of course not. The longer this goes on and the bigger it gets, the more fragile it becomes…Especially because the Fed, the ECB and BoJ are still working to control inflation. The Fed will continue to shrink its balance sheet, withdrawing cash from the banking system. Its two cohorts are a little less predictable, particularly the BoJ, but as long as the inflation numbers continue to run hot around the world, then the central banks will continue to attempt to drain money from the system by shrinking their balance sheets. Non-subscribers, click here for access.
So there’s that as an offset to the will of the players to continue borrowing and leveraging to drive asset prices higher. This rally will end, and it is likely to end hard, in tears. But for now, we can’t see from liquidity alone, when that will be. There are some things that suggest that the time is growing near for the first big correction. I will continue to monitor the liquidity measures for any hints of reversal, but as always, the technical analysis will determine when we should change tactics, even if, in this new world, it’s not always clear why, at first. Non-subscribers, click here for access.
In this report I present the most current banking, money market fund, and Fed balance sheet charts to illustrate what’s going on, and give us a leg up on specifically what to expect and look out for in the stock and bond markets. Non-subscribers, click here for access.
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