Hey There Income Hunter,

 

We have reached the point in the Fed monetary tightening cycle where the drain on liquidity can have a more dramatic effect on markets. 

 

That sound you hear is the market’s lifeblood (liquidity) being sucked out by rapidly decreasing margin debt – the US Treasury 

 

Until now, Treasury balances and very high bank reserve balances – both held at the Fed – provided enough liquidity to offset quantitative tightening and higher rates.

 

The markets were also being held up by record high margin balances, which have since reversed course and are now tanking.

 

Today, I’ll illustrate how the system is starting to leak oil and why that will demand more attention in the new year.

 

Liquidity Going Down the Drain

Last week, the Fed’s balance sheet fell to $8.6 trillion from a high of $9 back in April. Its bank reserve balances also fell near the lows of the year, around $3 trillion. 

 

As you can see in the chart below, there is a pretty tight correlation between both the Fed balance sheet and bank balances. 

 

 

This trend will put more pressure on the Fed to increase leverage in the banking system so banks can provide more liquidity to the markets

 

I believe that is a move we could see in the first half of the year. It is an easy step for the Fed and Treasury to take. What they would do is simply exempt the banks from the Supplementary Leverage ratio or the SLR capital requirement. 

 

Of course, it would add risk to the banking system, but the Treasury would ignore that if it meant more support for the financial markets. 

 

Margin Debt Meltdown
The even more direct draining of liquidity from the markets comes from margin debt trending sharply lower. There is a lag between margin debt and its impact on stock prices, but there’s no denying the trend. 

 

This is more of an interest rate issue, as borrowing costs and volatility in the markets have forced brokers to raise their cost for access to margin. 

 

Notice how tightly correlated the margin debt (red line) is with the NYSE index (blue line). 

 

 

The Line in the Sand

Illustrated below is the S&P 500 Index ETF (Ticker: SPY). The put wall, which represents the largest negative gamma strike, is a line in the sand for the market. 

 

Taking out 375 SPY would ignite an acceleration away from the tight range we have been trading in. 

 

 

The lack of liquidity near year-end would exaggerate the move even further.

 

Bring It Home 

Everybody is looking to China to come rescue the global economy now that Beijing is reopening.

 

I would love to see it, but with the COVID case count soaring, I’m just not sure if it will make a significant difference. 

 

For now let’s hope the market holds above SPY 375 into the new year when we will at least have better liquidity.

 

And in the meantime …

 

Live and Trade With Passion My Friend,

 

Griff