So Much For Quantitative Tightening

US stocks continue to post some of the highest levels of the past year, buoyed by streams of surprisingly strong economic data, quiescent levels of market volatility and the sheer market effervescence around myriad applications of artificial intelligence seemingly limited only by the breadth of imagination. Rose-colored glasses aside, the NASDAQ, S&P 500 and Dow Jones Industrial Averages all skate about their YTD highs set in early June as the summer months approach, feats all the more impressive given the drumbeat of a 500-basis point rise in the federal funds rate over 10 consecutive Federal Open Market Committee meetings since March 2022. Why?

It's the Liquidity

Copious amounts of liquidity now spill into financial markets worldwide with aplomb due to central banks’ all-consuming battle with historical high measures of inflation. The demise of three regional banks here in the US forced the Fed to inject substantial cash into the money market space to shore up banks hit hard by the epic fight. The newly minted liquidity program, Bank Term Funding Program (BTFP), now offers loans up to one year in duration with the pledge of Treasuries, agency debt and mortgage-backed securities valued at par. Backstopped by the Exchange Stabilization Fund up to $25 billion, the additional liquidity minimizes asset fire sales by banks attempting to meet the demands of nervous depositors.

By default, the resulting liquidity flow greases the wheel of equity markets—and will likely continue to do so for the duration of the Fed’s current quantitative tightening cycle and beyond. The effective Fed funds rate currently holds at 5.07% through June’s FOMC meeting. Markets have climbed down from projections of quantitative easing in the second half of the year. New projections now see with an 84% probability a 25-basis point rise in the Fed’s July meeting, bringing the effective fed funds rate into a range of 5.25% and 5.50% by the end of July with the end of year rate staying between 5% and 5.50% with a 69% probability.

Another source of market liquidity comes from the Fed’s balance sheet. True to form, the Fed continues to sell its security holdings into the market. Of course, further increases in the federal funds rate apply add parallel pressure on bank balance sheets, particularly those at the regional and local levels. By design, the Fed selling Treasuries and mortgage-backed securities to primary dealers pulls liquidity out of the market. In June 2022, the Fed held outright $8.5 trillion in securities. That total indeed fell by June 2023 to $8.3 trillion. Yet over the same period, the sum total of loans on the Fed balance sheet ballooned to $282 billion, up from $21.7 billion YOY. Absorbing a 500-b/p increase in the funds rate is a particularly tough pill for most banks to swallow, let alone digest—in the best of market conditions. In the second half of 2022, bond prices were at their highest level in over a century. The flip side of that equation saw bond yields at their lowest level over the same time as the federal funds rate hovered at zero lower bound. Now superimpose 10-consecutive FOMC fed funds rate increases over a wildly short 13-month period. Sketching out this picture becomes grizzly indeed. Bond yields rose and prices fell further and faster than at any other timeframe this side of the Paul Volcker years of the 1980s. The smell of bank runs, now communicated instantaneously via social media and digital news sources, hung ominously in the air across ever larger swaths of the country. It didn't take long for Fed policymakers to sniff out a solution.

Where do we go from here?

The need for further backstopping bank balance sheets assets will be greater, not less, moving forward. So much for the cumulative impact of quantitative tightening. Market liquidity will continue apace which should be a continuing boon for stocks, not to mention financial stability. And in a world where excessive debt, either at the household level or at the local, county, state or national levels of government, will likely keep central bank balance sheets burgeoning rather than shrinking for the foreseeable future.

On the bond side, the US Treasury continues to debate buybacks of Treasuries and mortgage-backed securities to improve the liquidity of the bond market. The jury is still out on this option and no policy options are currently close to implementation. Bond prices continue to fall, saddling holders with outsized capital gain losses while continued market volatility is likely to remain for the foreseeable future.

Moving forward, aging demographics and now heightened military expenditures are applying outsized pressures on public spending in advanced economies throughout the world. Sovereign debt crises and defaults are cropping up in an emerging number of low- and medium-income countries in Africa, the Middle East and south Asia. According to the latest projections by the Congressional Budget Office, the US Treasury will have to sell about $2 trillion/year over the next decade to keep pace with current budgetary outlays. The Fed’s treasury holdings will more likely increase over the next decade than decrease by any measurable degree. So much for QT.

Stocks will continue to enjoy copious levels of liquidity for the foreseeable future.