Air Pocket

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What’s Under the Surface?
The heart of “conditioning bias” comes down to one sentence. The longer something works, the more players get drawn into playing the game. We know the junkies are on every street corner these days buying call options when the VIX is up 29% since late December with equities as measured by the S&P 500 – up just a touch more than 9% higher. 

Over the last 30 years — most of the time, the CBOE Volatility Index has been supported by investors looking for downside protection in buying puts. But 2024 is much like 1999. For most of that year, the same thing occurred, Today, many players on the field say “greed is good” and they’re all buying upside.

They Love to Buy the 20 Day Moving Average
As the market grinded higher – more and more capital came into the hands of algos and quants buying the 20-day moving average. This is an important area to keep an eye on. There are so many players involved, that a violation of the 20-day moving average will likely come with a meaningful flush lower. 

What Could Alter the Equation?

In the next several weeks, we could see about $300 billion of liquidity leaving the system. This is in large part due to the tax deadline on April 15. We should expect large tax revenues, in part because taxpayers have significant capital gains from the 2023 equity bull run. Treasury bill issuance will flip negative in Q2 to the tune of about $150 billion as the government runs a budget surplus for a cup of coffee. Add to that the $95 billion in monthly QT (quantitative tightening, Fed balance sheet reduction) and we could see $250 billion of liquidity drain. On top of that, this month about $75 billion of the emergency bank lending facility (BTFP loans) expired and since the facility is now closed, they may not get renewed. This causes another contraction in bank reserves.

Keep in mind, that S&P 500 companies are still in the buyback blackout period, which means that they cannot buy back their stock until they have reported earnings. Stock buybacks are about $100bl per month, so this upward pressure on stocks is currently gone.

Equity Volatility is Cheap vs. Encroaching Risks

The combination of the cocktail ingredients listed above makes the market very vulnerable and at risk of a larger drawdown if any geopolitical risk comes to the surface. Each week, Iran and Israel look toward retaliation, and the probability of escalation is rising. Brent is up nearly 30% since December, putting significant pressure on higher bond yields. Over the same period, the yield on U.S. 10-year Treasuries has moved from 378bps (3.78%) to 440bps (4.40%).

One of the biggest drivers of the stock market since early 2023, and especially since late October, has been liquidity.  In an election year of course, Treasury Secretary Yellen and Fed Chair Powell have carefully rebuilt a big chunk of the excess liquidity that underpinned the stock market rally. The two main reasons for the liquidity boost have been to — a) stabilize the banking system after SVB (Silicon Valley Bank) blew up a year ago and — b) to suppress volatility in the election year. A large amount of that liquidity has come from the Reverse Repo Facility (RRP). This is a facility the Fed brought to life in 2020 to mop up some of the excess liquidity from all the Fed’s juicy new programs used to stabilize the financial system during the Covid Financial Panic.

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Remember, the Fed injected $3.3T of liquidity into the system that year. Fast forward to the end of 2022, and there was almost $2.5T in this RRP facility. Ever since, Treasury Secretary Yellen has been using this money in this honey pot, the RRP to finance her ~$2.5T of bill issuance. The way this works is that when the Treasury ramps up bill issuance, it will push up bill yields. At some point that yield we go above the rate on these reserve balances in the RRP. This is what the Fed pays investors, mostly money market funds, to keep money in the RRP. These investors get lured into the bills market with its higher rates and they take their money out of the RRP and buy bills with it. The money in the RRP is not considered to be part of overall liquidity, so if that money leaves the RRP and enters the bills market, it adds to the liquidity pool. Much of this money has ended up in a special component of the commercial banks’ balance sheet called the reserve balance held at the Fed. In the past, the Fed injected liquidity into the system via QE, which also increased these reserves. But in the last year, the bank reserves expanded primarily from the RRP depletion, and the Fed’s introduction of the Bank Term Funding Program in March of last year. This program allowed banks to borrow from the Fed and use their bonds at par as collateral. This was done to inject liquidity into the banking system to avoid a cash shortage at mainly regional banks following the blow-up of SVB.

Excess Liquidity, Bitcoin, and the S&PExcess liquidity have surged higher in the last year, which has pushed up risk assets, such as bitcoin and equities.

Together with the introduction of the BTFP in March ’23, the Fed and Treasury pushed up bank reserves from $3T on Oct 22, to $3.6T by March ’24. What do these reserves do? These reserves cannot leave the banking system and therefore cannot enter the “real economy”. It’s a financial form of money only for banks. They can transact in reserves with each other and settle repo and reverse repo transactions. They account for high-quality liquid assets (HQLA) together with bonds and mortgage-backed securities (MBS). Most importantly, banks use the reserves to buy bonds from each other. In this way, they drive liquidity into the market and drive investors into riskier assets. We see that almost every time reserves go up, risk assets benefit.

Bank Reserves Go Up when RRP Goes Down and Vice VersaAs the Treasury pushed money out of the RRP, bank reserves held at the Fed have gone up simultaneously. This has been one of the biggest driver of stock market gains

In the next few weeks, we could see liquidity reverse for two reasons.

1) Treasury bill issuance will flip negative in Q2 to the tune of about $150bl. In Q1, 400bl of capital went from the RRP into the bills market, and in Q2 this will reverse. Add to that the 95bl in monthly QT and we could see 250bl of liquidity drain.

2) Expiration of the BTFP. In April about 75bl of BTFP loans expire and since the facility is now closed, they may not get renewed. This causes another contraction in bank reserves.

Overall we could see over $300bl of contraction if Yellen/Powell do not step in to offset. We think they will step in but it might take a month or so for them to react.

In the meantime, we are still in the buyback blackout window ($100bl of monthly buybacks do not start anew until after GOOG/AAPL report in late April/Early May) so we could fly into an air pocket.

In the next blog post, we will explain how Yellen and Powell can and will come up with a solution if they see liquidity plunge too far or stock market volatility surges higher.