A Long Year

Think back to this time last year. Inflation was still “transitory”, the S&P 500 began its final bull run to 4,800, Tesla squeezed to $1,200 (pre-split), Ethereum approached $5,000, and the 1-year U.S. Treasury traded at a 0.11% yield.

The final months of 2021 marked the dying thrust of a liquidity fueled frenzy in financial markets that began in early 2020 at the beginning of the COVID pandemic. Quantitative Easing (QE) had overstayed its welcome, inflation was spreading, and the blanket-excuse of a COVID “emergency” seemed less persuasive by the day. True-believer enthusiasm for crypto, SPACs, and disrupters had long peaked and had been replaced with a cynical malaise. Even for the most ardent bulls, the whole thing must have felt a bit long in the tooth.

But few expected what was to come.

Just as 2020 and 2021 saw indiscriminate price increases across assets, 2022 has seen a near universal collapse1. Arguments like a slowing economy should lower bond yields or gold/bitcoin is an inflation hedge have proven incorrect. Bonds have experienced their largest yearly drawdown on record, stocks have fallen 25 - 35%, housing prices have peaked, and crypto has seen its market cap slashed by two-thirds.

Initially, the drawdown in asset prices was accepted as an appropriate correction from far too easy monetary policy. But today, global financial markets are growing increasingly dysfunctional as liquidity withers.

The relative strength of the dollar is now causing chaos for the rest of the world. In just the past several weeks, we have seen direct currency interventions from the Bank of Japan and the People’s Bank of China. The Bank of England was forced to again expand its emergency gilt buying operation, under the auspices of financial stability. The Swiss National Bank tapped the Fed’s swap lines for $3.1 billion. Even Treasury Secretary Janet Yellen is now concerned about the lack of liquidity in U.S. Treasury markets.

While the whiplash in markets over the past year has been dramatic, the underlying driver of the bull and bear market are the same. The rising tide of liquidity buoyed financial boats in 2020 and 2021, but the tide is now going out.

The Liquidity Pool

In previous posts we have described the technical mechanics of market liquidity, but today we will introduce a much simpler analogy. Imagine the financial market is a pool that looks like this.

In this crude analogy, the Federal Reserve is in charge of keeping the water at the right level to achieve its monetary policy goals. It can add water to the pool via QE, and it can pull water out with QT.

Higher water levels mean higher asset prices and lower asset yields. Meanwhile the slope of the pool from the deep end to the shallow end represents a risk and reward curve. As the water rises, it flows out into increasingly risky assets as they become more and more attractive relative to safer assets.

From late February 2020 until March 2022, the Fed poured $4.7 trillion of water into the pool. The intent and result was increased asset prices and lower asset yields. As the pool filled, water flowed into riskier and riskier assets as they became more attractive on a risk-adjusted basis.

By early 2021, the pool was full. Yields on short-term government securities reached zero percent and were heading negative.

Enter the Reverse Repo Facility (RRP).

The Reverse Repo puts a floor underneath short-term rates by allowing liquidity to spill over the side of the pool. The RRP is utilized primarily by Money Market Funds (MMFs), which invest in high quality short-term investments. Normally, MMFs provide liquidity to the U.S. Treasury by purchasing Treasury Bills or to the broader financial system or corporations through tri-party repo or commercial paper (CP) purchases. When a MMF uses the RRP, it gives its dollars to the Fed instead.

It is tempting to only think of the RRP usage as a transaction between MMFs and the Fed, without considering the downstream consequence. Namely, the U.S. Treasury or financial market participant must find funding from somewhere else instead.

In other words, if a MMF sells2 a 1-month Treasury Bill, someone else has to buy it.

Maybe someone will sell a 3-month Treasury Bill to buy the 1-month Treasury Bill if it has a similar yield with shorter duration. But of course this means someone else needs to buy that 3-month bill, and so on…

If you scoop a bucket of water out of one end of a pool, it effects the waterline of the entire pool evenly. Similarly, when the MMF removes a dollar from the market by placing it in the RRP, it effects all markets as liquidity redistributes across assets to fill the gap3.

When the Fed raised the interest rate on the RRP from zero to 5bps in June 2021, it didn’t just impact the Treasury Bill market but removed enough liquidity to increase yields across all asset classes to 0.05% on a risk-adjusted basis, as the pool rebalanced4.

During 2021, liquidity was flowing into the pool via QE and out via the RRP for a relatively stable dynamic. However, as QE began to wind down in late 2021, aggregate market liquidity began to fall dramatically.

Now, with each ongoing rate hike (and concurrent increase in RRP interest rate), more liquidity is removed from the market. Today, with the RRP rate at 305 bps, the Reverse Repo facility will drain enough liquidity to increase yields (and lower prices) across all assets to the risk-adjusted equivalent of 305bps on a 1-month bill.

An amusing example of this rebalancing is shown by the collapse in web traffic to Ethereum.org coinciding with a surge in traffic to TreasuryDirect.gov - a portal where individual investors can directly invest in government securities.

With QT now running at $95 billion per month, the RRP has less work to do on its own, but each subsequent rate hikes will lower the spillover threshold yet again. On November 3rd, the RRP rate will increase to 380bps and again to 455bps by December.

Since March 2021, $2.2 trillion has been removed from the market via the RRP, or a pace of nearly $120 billion of tightening per month for 19 months straight. Since the wind down of QE, net liquidity has dramatic declined, responsible in part for price declines across all financial assets and increasing strain on the global financial system.

Conclusion

Just as the Fed compressed yields at the onset of the pandemic by flooding the market with dollars, the only way it can now achieve its rate hike agenda is through removing a commensurate amount of liquidity. The primary tool for removing liquidity is not through QT but rather through the RRP which siphons off the requisite amount of dollars to achieve target the Federal Funds Rate.

The effect is not limited to short term money markets, but fans out across financial assets. As liquidity is removed, markets become volatile and fragile. The Fed may not care about destroying the crypto market, but when the risk makes its way to sovereign debt markets, it takes notice.

Now, the Fed is stuck between a rock and a hard place. Continued rate hikes will remove even more liquidity5, strengthen the dollar and raise the risk of global meltdown in financial markets. The alternative is to relinquish any remaining credibility by pivoting in the face of 6.6% core inflation to bail out financial markets, yet again.

Given that the Fed is anchored to its hiking path for the near term, it is the global financial market that is on the hot seat.

As always, thank you for reading. If you enjoy The Last Bear Standing, tell a friend! And please, let me know your thoughts in the comments - I respond to all of them.

-TLBS

The exceptions are energy and the dollar relative to other currencies.

2

It’s actually more likely that a MMF would not outright sell the Bill, but rather would wait for it to mature, and reinvest proceeds into the RRP. The consequence for market wide liquidity is the same. If the MMF does not reinvest proceeds back into Bills, someone else must fill the gap.

3

Theoretically. In practice, financial markets are not actually as seamlessly connected as this simple metaphor implies. There are millions of different assets each with their own characteristics risk profiles, and millions of different investors each with different mandates and objectives. It’s an analogy.

4

This risk-adjusted return concept is very hard to quantify in practice. What return should an investor demand on a stock that would be risk-adjusted equivalent to a 0.05% 1-month bill? We can use financial theory and equity risk premiums to approximate some equivalent figure, but there is no hard and fast truth, and it will likely differ across investors.

5

There are of course other policy tweaks that may be helpful in improving market functioning, like loosening regulations to expand balance sheet capacity at broker-dealers (SLR relief), but doesn’t change the underlying liquidity dynamics.

The Last Bear Standing

The Pool