The Fed's 'hidden stimulus” is coming, and the crypto market will benefit from liquidity

Original source: Tomas X account

Net Fed liquidity will rise in the coming months. This could be good news for stocks, gold and Bitcoin prices. Let me explain why.

Net Fed Liquidity measures the total liquidity entering the market directly from Fed sources. It can be considered a "stealth stimulus" measure in the United States, and can be influenced not only by the Federal Reserve, but more importantly by the US Treasury Department.

Since the beginning of 2022, the Federal Reserve has officially implemented tightening policy by reducing its balance sheet. But in reality, nearly $1 trillion in liquidity was injected into the market from December 2022 to March 2024. This is what caught many people off guard when the market rebounded in late 2022.

Net Fed liquidity has broad correlations with most asset markets. It fell in 2022 (along with asset prices) but bottomed out (along with asset prices) in late 2022 [Chart 1]. In particular, the correlation with Bitcoin is strong [Chart 2], while the correlation with stocks has been weaker in recent months.

[Chart 1]

[Chart 2]

My measure of net Fed liquidity includes the following five components:

1. Discount Window

2. Bank Term Financing Scheme

3. Balance Sheet

4. Treasury General Account

5. Reverse Repo

At any time, These five components either inject liquidity into the market or absorb liquidity from the market. The different components essentially pull in opposite directions, like a tug-of-war.

Net Fed Liquidity measures which side has the upper hand in the tug of war.

The important thing about net Fed liquidity is that its overall future direction can sometimes be predicted with relative accuracy.

So, What happens to net Fed liquidity in Q3 2024? Let's take a look at these five components and how they are likely to perform in the third quarter.

1. Discount Window - No significant changes

The Fed’s discount window is the banking industry’s “last straw” in emergencies.

Banks can borrow through the discount window, which is equivalent to injecting liquidity into the market. While the discount window is not significant most of the time, it rises sharply during periods of banking distress, such as the 2008 global financial crisis, the 2020 pandemic, and the 2023 regional banking crisis.

Currently, discount window usage is relatively high ($7 billion), but nowhere near historical “panic levels” and not enough to have a significant impact on the market. Most of the time, it's basically not worth considering -- and I think that will be the case in Q3 2024 as well. So we can ignore the discount window for now.

2. Bank Term Financing Program - Not much has changed

The Bank Term Financing Program (BTFP) is an emergency bank rescue measure launched by the Federal Reserve in March 2023.

During and following regional banking crises (such as the collapse of Silicon Valley Bank), banks borrowed approximately $165 billion from BTFP, which at the time was a

liquidity injection.

However, BTFP was shut down by the Fed in March 2024 and these loans now need to be repaid within 12 months, which removes liquidity

from the market when these loans are repaid.

I don’t expect much change in bank term funding programs in the third quarter, and if there is, it’s probably less than $20 billion. To simplify the analysis, we can also temporarily ignore this factor.

3. Balance Sheet - $75 Billion Liquidity Extraction

The Fed is currently engaged in Quantitative Tightening (QT), by selling its large holdings of US Government Bonds and Mortgage-Backed Securities (MBS) to reduce the size of its massive balance sheet. Quantitative tightening is a

liquidity extraction because when these assets are sold by the Fed, they need to be absorbed by the market, and the funds could be used elsewhere.

This is the easiest to predict because it is essentially a systematic process. The Fed's balance sheet will be reduced by about $25 billion per month in the third quarter, so Q3 QT will drain a total of $75 billion of liquidity.

4. Treasury General Account - $100 Billion Liquidity Draw

The Treasury General Account (TGA) is the government’s bank account with the Federal Reserve.

When cash sits idle in the Treasury General Account, it is effectively "dormant" and removed from the market, thus being a

liquidity draw.

Instead, when money in the Treasury General Account is spent, it re-enters the market, thereby

injecting liquidity.

Currently, the Treasury General Account balance is approximately $750 billion. In its latest quarterly refinancing announcement, Treasury projected the Treasury general account balance would reach $850 billion by the end of the third quarter. Let's trust the Treasury's forecast for now. This means there will be a further increase in the Treasury General Account (which draws liquidity from the market), expected to increase by about $100 billion. So, combined with quantitative tightening (QT) liquidity draws totaling $75 billion, the increase in the Treasury General Account would bring total liquidity draws to $175 billion.

5. Reverse Repo - $200 Billion to $400 Billion Liquidity Injection

Reverse Repo (RRP) is a tool of the Federal Reserve during the easy money era of 2020 and 2021 , where financial institutions park their cash to earn a fixed income. By the end of 2022, approximately $2.5 trillion was deposited in reverse repos. Since reverse repos and U.S. government Treasury bills (T-bills) are short-term assets with no credit risk, they are almost perfect substitutes.

To cover its huge deficit, the US government has been issuing T-bills in large quantities over the past 18 months. T-bills offered slightly higher yields than reverse repos, thus attracting approximately $2 trillion to be withdrawn from reverse repos to purchase newly issued T-bills [Chart 3]. This cash is transferred back to the money markets from the Fed's "freeze" and is therefore a liquidity injection.

However, reverse repos stopped liquidity extraction in Q2 2024 [Chart 4] as the US government temporarily stopped issuing T-bills in large quantities. This slowdown can be seen in a chart by @dharmatrade [Chart 5]. The chart shows that net issuance of T-bills significantly exceeded historical levels in 2023 and early 2024 before turning negative in the second quarter of 2024.

But this temporary slowdown in T-bills issuance will end in the third quarter of 2024. Plenty of T-bills will be issued again as the government tries to plug the "gap" in its massive deficit. Because of this coming flood of T-bills, I expect $200 billion to $400 billion to be pulled out of reverse repos in Q3 (I know that's a pretty broad range), which will be a liquidity injection .

[Chart 3]

[Chart 4]

[Chart 5]

Therefore:

• $200 billion to $400 billion in liquidity injections (reverse repos)

• $175 billion in liquidity withdrawals (quantitative tightening and Treasury General Account)

• Net flows The injection is between $25 billion and $225 billion

Let’s talk about the Treasury General Account again

Let’s go back to the Treasury General Account (TGA) again. So far, our calculations suggest there will be net liquidity injections in Q3. But that's assuming the Treasury general account balance was $850 billion in the third quarter.

I mentioned before that these Treasury General Account Balance "estimates" should not be taken too seriously. Since Janet Yellen became Treasury secretary, Treasury general account estimates have frequently been on the high side (sometimes by a lot).

Therefore, the Treasury general account balance is likely to be below $850 billion at the end of the third quarter.

We already have a third quarter net liquidity injection range of $25 billion to $225 billion assuming a Treasury general account balance of $850 billion. Any deviation from the Treasury general account balance below $850 billion would shift this range upward.

Forecast

Taking all factors into account, here’s the likely range for net Fed liquidity by the end of the third quarter and adding a buffer in case the Treasury General Account Balance estimate is wrong again:

Final note:

This analysis assumes that conditions will not change during the third quarter.

But there is still a small probability of events that may force the Federal Reserve to respond to certain problems in the financial system or sudden black swan events. This could include reopening the Bank Term Financing Program (BTFP), launching another similar bailout facility, halting quantitative tightening, restarting quantitative easing, or any other measure that can quickly inject more liquidity into the market.

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