Category: Fed, Central Bank and Banking Macro Liquidity

That’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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The Fed’s Reverse Repo (RRP) operations act primarily as a money market fund for money market funds (MMFs.) The MMFs were forced out of their T-bills in 2021-22 because the US Treasury was paying them down. The Treasury redeemed the T-bills and the MMFs got cash back. Not what they wanted. They need to earn interest on those funds.  Non-subscribers, click here for access.

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The MMFs were therefore in trouble. The Fed came to the rescue by opening its RRP operations to the MMFs. Previously, only Primary Dealers could participate. In effect, the Fed began subsidizing MMFs. As the Fed raised the rate it paid on RRPs, that increased the subsidy to MMFs, and their holders, mostly big investors. Non-subscribers, click here for access.

In this program, the MMF’s could place their excess cash with the Fed overnight and get a nice big fat, risk free, interest payment in return. The Fed imagines that money into existence. Non-subscribers, click here for access.

But the interest payments cut into the Fed’s surplus (aka profit). If the Fed loses money, that reduces the amount of surplus and ultimately, the taxpayer ends up paying for that. Nice. Taxpayers fund welfare payments to MMFs which are typically held by the wealthiest of the wealthy anyway. Therefore the Fed’s interest payments on RRPs are welfare for the rich. Non-subscribers, click here for access.

But I digress.

Once the RRPs were opened up to MMFs, RRPs outstanding ballooned. They got up to $2.6 trillion when the Fed rescued those couple of failed banks in March. Non-subscribers, click here for access.

Meanwhile, I have constantly warned that when the debt ceiling was lifted and the US Treasury started issuing T-bills again, MMFs would pull cash from RRPs to buy T-bills. It’s now happening. RRP balances have fallen by $275 billion since May 24, as the Treasury has been issuing wads of T-bills, including a net of $175 billion this week. Non-subscribers, click here for access.

The RRPs aren’t funding all of that, but they’re absorbing most of it. With T-bills being perfect collateral, they can be, and are, used for repurchase agreements from banks (RPs) whereby the bank will provide credit up to nearly the amount of the T-bill. RPs are like margin loans in that respect, except that the haircut is almost nothing. So the reintroduction of T-bills into the market provides collateral for more credit. More credit means more money to buy hot paper. Non-subscribers, click here for access.

And they’re buying it. Non-subscribers, click here for access.

Some of you have pointed out correctly that MMFs, particularly government MMFs, can only buy T-bills with their cash. But MMFs are only intermediaries. Who holds MMFs? That’s right, major investment institutions, hedge funds, and you and me, aka Ma and Pa investor.
We investors, both big and small, participate in the Fed’s RRP program through these intermediaries. And when we as a group start feeling bullish on balance, for no reason in particular, then we pull money out of MMFs and buy stocks, bonds, real estate etc. etc. etc. Non-subscribers, click here for access.

That’s what is happening now. The rationale for it DOES NOT MATTER. The fact that interest rates are higher now than last October when stocks bottomed, DOES NOT MATTER. The fact that the Fed is still steadily tightening monetary policy via QT DOES NOT MATTER. Non-subscribers, click here for access.

Yet.

QT will matter.

I’ll tell you when, and why, and what it will mean for your dining, listening, and investing pleasure. Non-subscribers, click here for access.

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But First, A Number

Before I get into the withholding tax data for May, the Treasury just posted the following on the heels of the signing of the debt ceiling deal. My reaction? HOLEE COWWWWW!!! Non-subscribers, click here for access.

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That’s $95 billion in new supply in 6 days. And that’s only the beginning, whoa whoa whoa whoa whoa whoa oh oh oh oh oh oh oh uh oh. Non-subscribers, click here for access.

You would think that that would leave a mark in T-bill trading, but so far at least, nothing has moved. It might be because the market was already at 5.42, which is 37 bp above the Fed’s RRP rate. Once again, the market leads, the Fed lags. The T-bills should start sucking money out of the Fed’s RRP slush fund. Non-subscribers, click here for access.

It’s all dead money anyway until investors decide that they want to use it for something else. If it stays in the RRPs, yes it’s available to spend on stocks and bonds, but there’s a reason that $2.2 trillion or thereabouts has just sat there for the past year. And if it gets pulled out to go back into the Treasury’s cash account for rebuilding to the desired $600 billion, that cash won’t be spent in the markets, or the economy either. Non-subscribers, click here for access.

That money is dead to me. It won’t be used to support stock and bond prices. As Treasury issuance explodes and the Fed continues to insanely pull $95 billion per month out of the banking system, something will break. That’s a given. Non-subscribers, click here for access.

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We look at the charts of the banking and Fed balance sheet data, and current tax collections, in the context of the above heading. The failure of the government to raise the debt limit will mean that the US Government will run out of cash to pay its bills within the next few weeks. The Wall Street cognoscenti, who have no sense, see that it will mean the end of the world. Non-subscribers, click here for access.

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I think that AI will end the world before a US technical debt default will. No doubt, given the rabid dogs in charge of the issue in the House of Representatives, there will be a technical default. They don’t care about the consequences, predicted or otherwise, because the vast majority of them are in safe seats backed by voters who don’t care and know even less. The only thing that matters to them is to stick it to the “woke” crowd. A debt default would certainly be one way of sticking a finger in the eyes of the woke. Non-subscribers, click here for access.

So my wild guess is that it will happen. Non-subscribers, click here for access.

But wait! There’s more. And you need to know what that is if you want to play to win. Or at least to save your skin. Non-subscribers, click here for access.

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The tectonic plates of the financial sphere are heaving. The fault lines are growing. Fissures are widening. Cracks are spreading. The pressure is growing in the substrata, and magma is boiling to the surface here and there, and there, and there.

The big one is coming. A financial earthquake the likes of which the world hasn’t seen in 96 years. We know where the epicenter will be. It will be on Wall Street. We just don’t know when. But the time is growing shorter. Non-subscribers, click here for access.

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We can study the underlying forces, but the best meters of the building pressures are the markets themselves, both bonds and stocks. As lenders become increasingly panicked, they will call in their lines. Borrowers, highly leveraged dealers, banks, and hedge funds will be forced to liquidate. The quake will be upon us in an instant. Non-subscribers, click here for access.

We saw all this developing more than a year ago. It was simply a matter of paying attention to the Fed’s Primary Dealer data and its banking system data. There was absolutely no mystery, and no doubt that it was coming. Non-subscribers, click here for access.

I pointed out in April of last year that the Fed had decided to stop publishing the banks’ unrealized losses on for sale securities. Whenever the Fed stops publishing a line of data that it could easily continue to publish there’s only one reason. They don’t want us to see it anymore. Non-subscribers, click here for access.

But it was already out there, and we used it to extrapolate the losses to the vast bulk of their securities holdings, where no mark to market is required. We recognized then that the system was insolvent, that if the banks were forced to sell their assets, they would be equally forced to recognize losses. I warned that that could result in contagion. Non-subscribers, click here for access.

If anything, at the time, I wasn’t worried enough about just how bad this could become. I wasn’t thinking about bank runs, particularly online instaruns. Now, I am. Because there’s nothing to stop these instant bank runs. Large depositors who are not covered by deposit insurance can, and do, move all their money in an instant when they smell trouble. The contagion is starting and there’s nothing the Fed or the Treasury can do to stop a serial meltdown. Non-subscribers, click here for access.

The markets have been remarkably sanguine about all this. But that that is in the process of changing. The debt ceiling is causing distortion right now as institutions shift the funds out of the durations where the greatest risk of default is perceived, and into those seen as less risky.
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