Category: Fed, Central Bank and Banking Macro Liquidity

NOTE! This report has been updated here with important previously overlooked information. 

Withholding taxes plunged in December. They are by far the largest component of Federal tax revenue. This was not an anomaly. It was a continuation of a downtrend that began in November. This trend is a sign of economic weakness, recession, and most importantly, the fact of less revenue than expected. The US Government schedules Treasury issuance on the basis of revenue forecasts. When revenue falls short of the assumption underlying the supply forecast, it means that Treasury supply will increase. Now this will come from an already heavy forecast level in the first quarter. Non-subscribers, click here for access.

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Despite market expectations of lower interest rates ahead, the Fed is not yet refilling the punchbowl. The existing punchbowl, the Fed’s RRP facility, continues to be drained. It will run out of funds xxxxxxxxz xxxxxx xxxxxxxx xxxxx xxxxxx. Only the timing is at issue. The fall in tax revenues suggests that the day of reckoning will come sooner rather than later. I’m back to projecting xxxxxxxxx xxxxxxxxxx xxxxxxx, but we’ll adjust that expectation as we determine day by day xxxxxxxxx xxxxxxx xxxxxxxx xxxxxxxx, and whether RRP slush fund withdrawals are xxxxxx xxxxxxxx xxxxxx xxxxxxxxx.  Non-subscribers, click here for access.

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Tracking total Primary Dealer financing, as reported weekly by the New York Fed, shows us the approximate level of risk inherent in dealer positions. This analysis includes not only their outright positions, repo financing, but also net Treasuries borrowed, which is a proxy for short positions that hedge outright positions held. We then include dealer fixed income futures hedges. This combined view tells us whether they are long or short on balance. It also gives us a view of how leveraged they are. Non-subscribers, click here for access.

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The dealers have gone whole hog in terms of repo borrowing and maximum leverage since September. They first got there in mid-July. That was reversed by a period of deleveraging that lasted into September, accompanied by weaker markets. But then they came roaring back, pedal to the metal, with maximum leverage. Non-subscribers, click here for access.

At the same time, money has poured out of the Fed’s RRP slush fund at a breakneck pace as investor psychology turned more and more bullish. The Fed even followed the crowd this week, suddenly pivoting its guidance toward rate cuts next year, surprising the markets. Non-subscribers, click here for access.

$900 billion in cash has come out of the Fed’s RRP facility since September. Market participants have used that cash to buy not only T-bills, but also stocks and bonds. Combine that with the increased use of leverage by the dealers over that same period, and a temporary reduction in Treasury supply in December, and the stock and bond markets have been on fire. Non-subscribers, click here for access.

This too shall pass, but the question is when. The Primary Dealer positioning data alone doesn’t tell us that, but it does give us an idea of the elevated level of risk. It suggests that when Treasury supply returns to normal, and the RRP slush fund runs dry, the markets could be in for a sudden and violent turn. Non-subscribers, click here for access.

I initially estimated in prior reports that the RRP facility was heading toward zero in xxxxx, but as the pace of withdrawals has accelerated in the past few weeks, we adjusted that to xxxxx. The current data through Friday suggests that that’s still the target. But before that, Treasury supply will mushroom again xxxx xxxx , and will be heavy in xxxxxx. The ruts in the road should start to show up then. Non-subscribers, click here for access.

With the Fed’s pivot in rhetoric this week, the euphoria has been thick. Light T-bill supply until xxxxxxx xxxxxxx xxxxxx should keep that going. Meanwhile investors and dealers have continued pulling money out of the Fed’s RRP facility at a breakneck pace over the past couple of weeks with no T-bill supply driving that. That means that instead of simply buying T-bills as they usually do with that cash, with the T-bills then being used as collateral for more repo borrowing, dealers and investors have gone to directly buying stocks and bonds. Non-subscribers, click here for access.

I see no reason for that to change over the next xx xxxxx. But a big Treasury coupon settlement in xxxx xxxxxx xxxxxxx should present a roadblock, with more supply in xxxxxx xxxxxxx xxxxxx xxxxxxx giving an overleveraged dealer market a reality check. Non-subscribers, click here for access.
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When the 10-year yield hit 5%, we recognized that it was time for a bond rally. It has come with a vengeance. Now it is time to start looking for signs of a bearish turn there as we head into xxxxxxxx xxxxxxx xxxxxxx. Stocks should follow suit as investors wake up to the fact that the cash that fueled the buying frenzy will soon run out. Non-subscribers, click here for access.

Bottom line, I would not be xxxxxxx xxxxx xxxxxx xxxxxx but xxxxx xxxxxxx xxxxxx xxxxx. Non-subscribers, click here for access.

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Back in the good old days of QE, liquidity analysis was straightforward. The Fed pumped money into the markets via the conduit of Primary Dealer trading accounts and stocks and bond prices went up. When the Fed paused a couple of times, prices also paused, even came down a little. Then the Fed would start pumping again and up prices would go.

Easy-peasy. Non-subscribers, click here for access.

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We caught on to that game soon after the Fed started buying Treasuries direct from the Primary Dealers in March 2009. In fact, from the time I first started closely tracking the Fed’s daily open market operations against stock prices in 2002, we knew that there was a correlation. Non-subscribers, click here for access.

As a result, when they started QE, I was concerned that it would have a massive influence on the markets, creating a gross distortion with largely unknowable negative consequences. We then got to live the nightmare of central bank market manipulation for a dozen years. But at least it was easy to see and forecast cause and effect. Non-subscribers, click here for access.

From mid 2014 until late 2017 the Fed held steady. Then Janet Yellen began shrinking the balance sheet in late 2017, in what they called “normalization” and I called “bloodletting.” It didn’t work. The Treasury kept pedal to the metal in debt issuance and the market couldn’t handle it. This was despite the BoJ and ECB taking the handoff from the Fed. They printed like mad from 2015 through 2017 while the Fed was in pause mode. Non-subscribers, click here for access.

The ECB and BoJ got on board with “normalization in 2017-19. Stocks started to rebound after a hard selloff in 2018. Non-subscribers, click here for access.

Janet started the bloodletting in 2017, for which she gets no credit, and US stocks and bonds had a series of mild cases of diarrhea. That led to the September 2019 repo market “plumbing problem.” Yeah, it was a plumbing problem alright. The toilet got stopped up with TP—Treasury paper. Jay the plumber kneeled down and gave the market “Not QE.” It got quite a response. Non-subscribers, click here for access.

But the $400 billion of “Not QE” was a mere drop in the bucket compared to what was to come. The Pandemic Panic. The Treasury issued, and the Fed bought, a couple of trillion in new debt in the space of a couple of months. You see that on the left side of the chart. Then the Fed continued this new round of QE for another 18 months at a slower pace, despite the fact that it wasn’t needed. The US economy had already begun to recover and had gotten up a head of steam. Even the working poor got helicopter money. Of course, hedge fund operators continued to get paid, while Ma and Pa Saver continued to get zilch, i.e. ZIRP on their hard earned savings. Non-subscribers, click here for access.

All of that money printing made it easy to make money in the market. The Fed bought or financed almost all of the Treasury issuance. Fed credit begat animal spirits, private credit creation, and increasing leverage. Bulls were all geniuses, and bears were all idiots. Non-subscribers, click here for access.

It was easy because it was predictable. The Fed and Treasury always told us exactly what to expect in advance. More debt. More money. Non-subscribers, click here for access.

Now it’s not so easy. We’re still getting the more debt part of it, only the Fed ain’t payin for it any more. Nor are the ECB or the BoJ. Curmudgeons all. Non-subscribers, click here for access.

The Fed stopped QE and started draining money from the banking system with what we call Quantitative Tightening, or QT, in April 2022. Starting with the months where the Fed was ending QE, we had a bear market for 21 months. We see that in the center of the chart. Non-subscribers, click here for access.

Then, recovery began in October 2022 despite the fact that the Fed was still curmudgeonly. We see that on the right third of the chart. Non-subscribers, click here for access.

Just how did they accomplish that levitation act? The Fed had a trick up its sleeve. This report tells and shows exactly how it works, and how we know exactly when it will stop working. Non-subscribers, click here for access.

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Despite what the pundits tell you, and despite the massive rally in the Treasury market over the past few days, the problem of Treasury supply isn’t going away. These rallies have come along like clockwork ever 6 months since the bear market started 40 months ago. This one gets its start from the same conditions that spawned the last 3 rallies. So is this time different? Non-subscribers, click here for access.

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No. Non-subscribers, click here for access.

Last week the Treasury reported out its quarterly refunding data, including the TBAC forecast for the next 5 months. Again, the Wall Street captured media was happy to report that the top was in in yields for the umpteenth time, and therefore the bottom was in for the bear market in bonds. The bear market that they seemingly just noticed in the past 4 weeks. When the 10 year hit 5%, the pundit parade hit the streets and the airwaves to declare that the top was in (bottom in prices). Just like all those other times Wall Street correctly called a bottom or top in any major market right on the button. Remember those times? Non-subscribers, click here for access.

So let’s look at a few facts, along with the charts of the 10 year yield to get an idea of just how far this latest rally will go, and to look at whether, indeed, the Treasury market low (or high, depending on which side of the coin you are viewing) is in for good. Non-subscribers, click here for access.

After doing that, as shown in the following pages, I came away with this: Non-subscribers, click here for access.

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Composite Liquidity is flat and will almost certainly remain no better than flat for as long as the Fed continues to shrink its assets. There’s been just enough private credit creation, that is, money creation, to offset the Fed’s QT. So total liquidity goes nowhere. If bank deposits or foreign central bank purchases of US securities shrink, or if bank sales of Treasuries increase, the CLI will turn more negative. Non-subscribers, click here for access.

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That’s bad news for stocks and bonds, which have lately been doing poorly enough even with flat liquidity. That’s because constant massive Treasury issuance sucks more money out of the financial sphere than buyers of Treasuries have been creating by using repo to finance their purchases. Non-subscribers, click here for access.

Since the Fed started QT and liquidity turned flat, we have seen a shift in the overbought/ oversold parameters from what they had been under QE. We have an idea of where oversold is from the low one year ago. But as for overbought, we don’t have any idea. We only know that liquidity remains a constraint to upside progress, and an incentive for liquidation. So there’s reason to think that even if the CLI stays flat, the S&P will xxxxx xxxxx xxxxx xxxxx low around 3585. Non-subscribers, click here for access.

Meanwhile, an opinion I stated in June proved itself. Non-subscribers, click here for access.

6/6/23 Just imagine for a moment how bullish sentiment would become if the market tested the old high. The froth would be off the charts as virtually everyone would conclude that it was a new bull market. But without QE, it would not be. It would be a major top to end a cyclical bull market within a secular bear market. Non-subscribers, click here for access.

We’ll leave that determination to technical analysis. For our purposes here, the current liquidity tableau simply doesn’t support a long-term bull trend. But neither does it rule out an extension of the current rally. Non-subscribers, click here for access.

By July, Wall Street had turned bullish. Even the long-term technical indicators that I follow looked bullish. But these liquidity indicators were flashing red, which I noted in reports in August and September. Non-subscribers, click here for access.

The conditions that led to those red flashing lights have not been corrected. Non-subscribers, click here for access.

Such liquidity indications tend to precede long major cycle swings in prices. In that respect we are probably in the first stage of another major cycle bear market within a secular bear market similar to the late 1960s to 1982 and 2000-2009. Non-subscribers, click here for access.

Here’s the supporting evidence including charts showing exactly why we should expect this outcome. And I’ll tell how I’m looking at it tactically and strategically for your consideration. Non-subscribers, click here for access.

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