US$’s liquidity crisis
The liquidity shortage is why the Fed is resuming QE. It might perpetuate the equity bubble for a few more months until bond yields start rising again. Maybe not.
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At the October FOMC meeting, the Fed Funds Rate was cut by ¼% to a new target rate between 3.75%—4.00%, and quantitative tightened was abandoned to be replaced by quantitative easing.
Effectively, it was an admission that credit in the markets is too restrictive, which combined with the most recent Beige Book indicating that the economy might be stalling, was sufficient for the Fed to abandon inflation-targeting in favour of its other mandate — protecting employment.
Much has been written about the plumbing in the monetary system and why there is a liquidity crisis.
But rationalising it, the credit liquidity problem is being triggered by US Treasury borrowing, which relies heavily on short-term financing.
It is sucking liquidity out of markets.
Money market mutual funds (MMMFs) have grown to $6 trillion in the last year, and they can only invest in short-term US Treasury debt, which is overwhelmingly T-bills.
Issuance of T-bills dominates the Treasury’s funding activities, illustrated in the graph below:
It should be noted that the high volumes of issuance include turnover, as bills with maturities of as little as two weeks being repeatedly rolled over.
But note that the increase in MMMFs of some $900 billion in the last year is funding a significant portion of the Treasury’s new debt.
The origin of MMMFs is the deposit accounts of their investors at the commercial banks.
Effectively, these deposits temporarily exit the banking system into the Treasury’s general account at the Fed, pending it being spent back into public circulation.
An accumulation in the general account amounts to a net withdrawal of credit liquidity from the system.
Since early September, the general account balance has increased by over $350 billion:
Together with the Fed’s quantitative tightening which reduces bank reserves at the Fed, you can see why the system is under a liquidity strain.
And it explains why the Fed stopped QT.
The Fed reducing its funds rate in December won’t alleviate the credit crunch, which allowed Jay Powell to back off from definitely doing so.
Instead, the Fed needs to inject liquidity into the system by resuming quantitative easing.
By buying treasury debt off pension funds and similar institutional investors, cash is credited to their bank accounts at the Fed, and the banks in turn credit the accounts of the investors.
Further considerations
It is no coincidence that the last round of aggressive QE preceded a sudden and generally unexpected inflation spike.
A new round, albeit unlikely to be nearly as aggressive is bound to push CPI inflation higher and bond yields with it.
Last time, the yield on the 10-year US Treasury note was already rising from its low of 0.5% by the end of the covid year (2020).
And by the time the Fed stopped QE its yield had risen to 3%.
The Fed was forced to continue raising its funds rate to 5.25%—5.5% for a further year, bankrupting some regional banks and pushing the S&P 500 down by 25%.
We are embarking on this route again.
The question we need to ask ourselves, among others, is what are the consequences for the credit bubble and equity stock valuations?
If, as seems certain bond yields and CPI inflation start rising as a consequence of the Fed’s monetary easing, then the bubble is bound to implode.
It is hardly surprising that given the post-covid experience of QE there is increasing nervousness in markets.
The most extreme form of equity, which has no assets and no earnings is already threatening to lose its bullishness.
We refer, of course, to bitcoin:
Breaking down through its moving averages, an apparent loss of bullish momentum, and threatening to break under $100,000 is a very good indicator of the febrile sentiment in tech stocks generally, with which bitcoin correlates.
But easier credit conditions could, in the short-term, encourage one last bullish fling of equities taking it into earlier next year, before the reality of rising bond yields begins to bite.
However, don’t bank on it.
Talking of banking, we can begin to see why it is that senior commercial bankers are now talking gold higher.
It’s their business to worry about these things, and they can see the fix that the Fed is in, and how there is no alternative to the destruction of the dollar’s purchasing power.
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