Stocks Are Taking Off on A 'Liquidity Rally', Yet How Long Can Liquidity Support US Stocks?

As of December 26th, the S&P 500 Index soared to 4774.75, skyrocketing 24.36% this year and nearing its all-time high, while the Nasdaq hit its highest level in nearly two years.

The December FOMC meeting's dovish pivot by the Fed and the rapid decline in US Treasury yields captured almost all of the market's attention. However, there is another way to explain the surge in stocks: liquidity rally.

US liquidity primarily stems from four sources, including the Fed assets, the Fed’s Bank Term Funding Program (BTFP), the treasury general account (TGA), and the reverse-repo window, or ON RRP.

According to Nomura, although the Fed left the policy rate on hold, it continues to engage in quantitative tightening (QT) at a brisk pace, running the balance sheet off at the rate of $95billion a month. On the whole, therefore, the US central bank is still tightening.

Since embarking on QT, the Fed has absorbed more than $1trillion in funds from the market. Moreover, Chair Powell has suggested QT is likely to continue even after the Fed starts getting closer to cutting rates sometime next year.

Nomura analyst Richard Koo said Interest on excess reserves (IOER) is the reason why Fed is rushing ahead with QT. Central banks that raise interest rates after engaging in quantitative easing (QE) must make massive interest payments in the form of the IOER—the interest rate paid on excess reserves held by commercial banks in their current accounts at the central bank.

If a central bank that has implemented QE but has not finished absorbing the liquidity it created decides to raise interest rates, it needs to pay the new, higher rate of interest on all excess reserves held by commercial banks. Otherwise, those banks might lend the money out at a rate lower than the policy rate, thus rendering the rate hike meaningless. But given the quantity of excess reserves that exist today, associated IOER payments will be massive.

The Fed introduced the Bank Term Funding Program, or BTFP, earlier this year as the banking crisis roiled markets. The program allows banks and credit unions to borrow funds for up to one year, pledging US Treasuries and agency debt as collateral valued at par. The rate for these loans - one-year overnight index swaps plus 10 basis points — is currently 4.84% and 56 basis points lower than the rate for interest on reserve balances.

Since the Fed’s pivot earlier this month to forecasting more interest-rate cuts next year, OIS rates tracking them have tumbled, taking BTFP’s with them and boosting the attractiveness of the arbitrage trade.

With the debt ceiling resolved, the Treasury department must replenish its checking account at the Fed, called the Treasury general account, or TGA.It does this by issuing new Treasury securities. As cash is paid to the Treasury, this also saps liquidity.

According to Apollo, Treasury auction sizes will increase on average 23% in 2024 across the yield curve, The 37% increase in issuance of 3-year notes and the 28% increase in issuance of 5-year notes will in 2024 stress-test demand for Treasuries in the belly of the curve. In particular, if the Fed next year will start cutting rates and wants to soften financial conditions.

The RRP is best thought of as a bucket of dormant liquidity. Falling RRP balances mean that cash is being deployed elsewhere in the market — a liquidity injection. But now the reverse repo balance has dipped below $1.15 trillion, a 57 per cent decline from $2.6trilions.

According to Morgan Stanley’s Mike Wilson, the Fed's reverse repo drain is a reserve build, it has continued to help fund the Treasury's elevated amount of issuance over the past 6 months. But as QT thrums along and the TGA expands, the liquidity headwind to stocks will grow, and the RRP can only partly offset that. If US liquidity has been holding up the stock rally, it won’t for long.

Mooers, what are your thoughts on whether liquidity will still support US stocks in 2024?

Source: FRED, Bloomberg, Financial Times, Apollo, Nomura