Despite the surge in Treasury debt issuance and the subsequent drain of liquidity from financial markets, the U.S. stock market shows no signs of slowing down in its 2023 rally.
According to FactSet data, the S&P 500 index has already gained approximately 19% year-to-date, while the Nasdaq Composite Index has skyrocketed by 37% and the Dow has seen a 6% increase.
This bullish performance of stocks might come as a surprise considering the Federal Reserve’s decision to hike interest rates, investors’ shift towards bonds, and the liquidity drain caused by significant Treasury debt issuance to replenish the depleted U.S. government coffers due to the debt-ceiling issue.
Interestingly, not only have stock prices surged, but so have cryptocurrency prices, reflecting a broader market optimism. Additionally, the junk-bond market and the shares of heavily indebted companies like Carvana have also experienced a rally.
BofA Global rates strategist Mark Cabana and Katie Craig shed light on this phenomenon by explaining why the liquidity drain has not significantly impacted most financial markets, contrary to expectations.
Money-market funds, which were previously invested via the Fed’s overnight reverse repo facility, have now reallocated a significant portion of their cash to the influx of new Treasury bill issuance.
Contrary to consensus views, Cabana and Craig state that the debt-limit resolution’s liquidity drain will primarily affect the Fed’s overnight reverse repo facility by 90%, with only 10% impacting reserves. They expect this trend to continue, deferring any aggregate banking reserve scarcity until at least the second half of 2025.
Overall, despite ongoing liquidity concerns, the U.S. stock market continues its upward trajectory in the face of various challenges, demonstrating resilience and creating opportunities for investors.
The Fall in the Fed’s Overnight Reverse Facility Usage
The usage of the Federal Reserve’s overnight reverse facility has experienced a decline recently, dropping to approximately $1.7 trillion from its peak of nearly $2.6 trillion in December. Despite this decrease, the facility’s daily rate of 5.05% remains competitive with short-term bill yields.
Comparing Treasury Bill Yields
According to FactSet, the one-month Treasury bill yield TMUBMUSD01M is currently at 5.28% on Wednesday, while the 6-month rate TMUBMUSD06M stands at 5.48%.
Surprising Lack of Bill Cheapening
The BofA Global team expressed surprise at the modest depreciation of bills, stating, “We have been surprised by only modest bill cheapening.”
Analyzing the Fed’s Balance Liquidity Drain
The team further analyzed the factors contributing to the Fed’s “balance liquidity drain” since early June. It identified $469 billion resulting from the Treasury’s rebuilt cash balance and an additional $88 billion from balance sheet reduction.
Increasing Policy Interest Rate
Furthermore, the Fed’s policy interest rate has been raised to a range of 5% to 5.25%, marking the highest level since 2007. Another 25 basis-point hike is expected next week. Additionally, the Fed’s balance sheet has contracted from a peak of nearly $9 trillion to approximately $8.3 trillion.
Anticipating Future Liquidity Drain
The BofA Global team predicts that the liquidity drain will persist until a recession occurs, market functioning issues arise, or banking reserves face scarcity.
Read: Why one analyst thinks a possible recession could still arrive by February
Looking ahead, experts like Cabana and Craig project a balance of $0 on the Fed’s overnight reverse repo facility by September 2025. They anticipate a reduced Fed balance sheet that reaches around $6.4 trillion, ultimately marking the end of quantitative tightening and the policy of shrinking the balance sheet.