QVMS - Signs Of Stress Are Building In The Market

Summary

• Reserve balances fell below $3 trillion this past week.
• That is the first time since November 2020.
• There is now clear signs of stress forming in financial markets.

Liquidity remains a significant problem for equities and financial markets overall. This week reserve balances held at the Fed fell below $3 trillion for the first time since November 2020. It probably isn't by chance that the S&P 500 is trading at its lowest level since November 2020.

The sharp decline in reserve balances has been driven by a significant increase in reverse repo activity as we have approached the quarter end. On September 29, reverse repo activity hit a record high of $2.371 trillion. The big unknown is how far reverse repo activity will fall next week as the new quarter begins or if it should fall.

With an increasing amount of stock market volatility and higher interest rates, the appeal of investors parking cash in money market funds certainly is higher. Considering that most of the money that goes into reverse repos comes from the money market accounts, it isn't clear at this point that repo activity will drop by all that much. Even if the activity declines, it may be stuck in that $2.2 to $2.3 trillion range even once October begins. It is also possible that if stock market volatility rises, more money piles into the overnight repo facility.

Additionally, the size of the overall Fed balance sheet continues to drop as Treasury and MBS securities roll-off due to quantitative tightening. The balance sheet fell this week to $8.796 trillion from $8.805 trillion last week and is down from a record high of $8.965 trillion on April 13, 2022. The further the overall size of the balance sheet drops, the more reserve balance will fall.

While it isn't apparent yet, the shrinking balance sheet and falling reserve balances may contribute to liquidity strains in the equity market and potentially in the overnight and dollar funding markets. Since the beginning of September, the FRA-OIS spread, which measures the difference between the 3-month dollar LIBOR and US federal funds effective rate, has rocketed higher and is a sign of increasing overnight funding stress.

Additionally, we have seen stress in the 3-month euro-dollar OIS basis swap, and the 3-month yen-dollar OIS basis swap spreads. Both currency swaps have recently seen their spreads fall dramatically and suggest that dollar funding strains rise as investors scramble for US dollars.

While these stress gauges certainly are not at alarming levels, they are sure signs of increasing liquidity strain in funding markets. These strains should be monitored for further signs of potential stress beneath the surface.

There is also stress in credit markets, with spreads that have widened and are at or near their highest levels during this current market downturn. These are just another measure of the stress that is developing beneath the surface, and the wider these spreads get, the worse the outcome will be for equity prices.

What is clear is that liquidity in the market is thinning out, and some strains are now forming within multiple layers of the market. This stress may be nothing and the result of a market transitioning from a period of easy monetary to tightening policy, or this could indicate that financial conditions are tightening and that the tightening is straining the entire financial system and the start of a much bigger problem.

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