Equities: liquidity constraints
Volatility will rise via curbs on settlement medium
It is now well over three months since the Fed began the process of shrinking its balance sheet. It is still too early in the process to be sure of the effects on financial markets. But an increase in realised volatility compared to the last decade looks certain.
On the Fed’s balance sheet RRP now stands at 66 percent of the level of system reserves while those reserves are, in general, falling. In balance sheet terms, Fed liabilities have turned away from reserves and towards RRP.
This trend leads to two thoughts. First, the short-term money market signal may no longer function as an early warning signal for general liquidity constraint. Repo rates look set to remain dominated by excess demand from money market funds. The result is persistent downward pressure on repo rates and so no early warning likely unless/until the Fed’s balance sheet shrinks by a lot more. This is utterly new ground. In both 2007 and 2019, short-term rate pressure caused the Fed to reverse policy. The Fed is highly unlikely to obtain that signal in this cycle.
Secondly, the lack of warning signal does not mean that liquidity danger is absent. The configuration of RRP means liquidity constraints are being shifted away from repo and into other market sectors. The most likely to be affected is the securities settlement process, dominated by FedWire transactions using system reserves of the banking system.
It is apparent from data from SIFMA that elasticity in liquidity is highest in equity markets. While average daily turnover of US Treasuries (the only market comparable in size to US equities) has remained relatively stable since 2019 (March 2020 excepted), the ADV of equity markets doubled from 2019 (~$320bln ADV) to early 2022 ($759bln ADV).
If not more importantly, the ADV in US equity markets have fallen by a huge amount this year (down 50% in August from January levels) just as pressure on settlement medium is increasing.
Now August often shows the lowest liquidity of the year, but 2022 is an outlier at 1.75 standard deviations lower than average liquidity through the first 8 months of the year. Again Equities stand out against other major markets.
Lower liquidity , possibly reflecting tighter settlement conditions may not mean that equities will deliver negative returns. Higher than expected growth, lower inflation and an outbreak of peace are all to be hoped for. That said, lower liquidity in settlement medium will increase the realised volatility of equities. Falling reserves from QT will reduce the available settlement medium and so maintain or increase this volatility. The risk attached to equity investment will become permanently higher than we have become used to.