Declining liquidity could sabotage a year-end rally

Markets have been soaring since the release of the October CPI report, which was cooler than expected, and has fueled expectations for an end to year rally. But, an end-of year rally is not guaranteed. There may be liquidity issues that prevent it from happening. happening and potentially send the S&P 500 (SP500, SPX) to Neue lows.

The US Treasury noted It announced on October 31 that it will issue $550 billion of debt by the end of the year. This will push its end-of-2018 cash balance to $700 billion. It will then work to reduce bank reserve balances at Fed lower, potentially below $3 trillion.

The Treasury General Account

The Treasury General Account at the Fed was $527 billion as of November 9. This means that the TGA must increase by approximately $173 billion between now-end of the year. That increase in the TGA will work to drain reserve balances and negatively impact the equity market and the S&P 500.

As noted previouslyA rising TGA combined with reverse repurchase arrangements (repos), drains reserve balances. Falling reserves balances have helped to drain liquidity from markets and push equity valuations down. The reserve balance at $3.07 Trillion, the very lowest end of its range in the past year, stood as of November.

Plunging Reserve Balances

The TGA account would see its total reserve balances rise by $173billion, which would bring them to $2.898 trillion by year’s end. However, reserves could fall further than that. December not only marks the quarter-end but also the year-end. As Government Sponsored entities funnel money into reverse repos, reverse repo activity tends to pick up in the second half every month. It rises even higher towards quarter-end. Reverse repos quickly surpassed their previous highs in December 2021. Reserve balances are also being drained by rising reverse repos.

The reverse repo activity peaked in September at $2.425 billion. This is $225B more than the $2.2 Trillion seen on November 10. Assume that repo activity reaches its September high and continues into the end year. In this scenario, $225 billion more would be taken from the total reserve, bringing the reserve balances to $2.67 trillion at the end of December.

Importantly, even though reverse repo activity doesn’t increase, it remains the same, this still suggests a new lowest reserve balances. Stocks have fallen to new lows in several trading sessions over the past year when reserve balances reached new lows. This includes February, April and June, as well as September.

Potential Market Impact

It is possible to estimate the potential market impact should reserve balances drop because the S&P 500 market cap has typically traded around ten times the size of reserve balances. Currently, the S&P 500 is trading around 10.66 times the size of reserve balances. Assuming the multiple stays the same, a decline in reserves to $2.898 trillion would value the S&P 500 around $30.9 trillion. A drop of reserves to $2.67 trillion would reduce the market cap to approximately $28.46 billion. This would mean a drop of 11.3% to 18.4% in market capitalization from $34.8 trillion. That would value the S&P 500 around 3,275 to 3,540.

Reverse repo activity can be tracked easily because these numbers are published by the NY Fed daily. TGA tracking is harder because it is only updated every Thursday afternoon by the Fed.

So not only may it be more challenging than it seems for the market to rally into the year-end, it may come as a surprise to many if the S&P 500 makes a new low.