The arrival of the Federal Reserve's "invisible stimulus" will benefit liquidity in the cryptocurrency market

Original source: Tomas X account

Author: Tomas

Compiled by: Shenchao TechFlow

In the coming months, net Federal Reserve liquidity is expected to rise. This could be good news for the prices of stocks, gold, and Bitcoin. Let me explain the reasons.

Net Federal Reserve liquidity measures the total liquidity entering the market directly from Federal Reserve sources. It can be seen as the "invisible stimulus" of the United States and is influenced not only by the Federal Reserve but also, more importantly, by the U.S. Treasury.

Since early 2022, the Federal Reserve has officially implemented tightening policies by reducing its balance sheet. However, in reality, nearly $1 trillion of liquidity was injected into the market from December 2022 to March 2024. This is why many were caught off guard during the market rebound at the end of 2022.

Net Federal Reserve liquidity has a broad correlation with most asset markets. It fell in 2022 (along with asset prices) but bottomed out at the end of 2022 (along with asset prices) [Chart 1]. In particular, it has a strong correlation with Bitcoin [Chart 2], while its correlation with stocks has been weaker in recent months.

[Chart 1]

[Chart 2]

My measurement of net Federal Reserve liquidity includes the following five components:

1. Discount window

2. Bank Term Funding Program

3. Balance sheet

4. Treasury General Account

5. Reverse repos

At any given time, these five components either inject liquidity into the market or withdraw liquidity from it. Different components essentially pull in opposite directions, like a tug-of-war.

Net Federal Reserve liquidity measures which side is winning in the tug-of-war.

The importance of net Federal Reserve liquidity lies in its future overall direction, which can sometimes be predicted relatively accurately.

So, what will happen to net Federal Reserve liquidity in the third quarter of 2024? Let's take a look at these five components and their potential performance in the third quarter.

1. Discount Window - No Significant Change

The Federal Reserve's discount window is the "last resort" for banks in emergencies.

Banks can borrow through the discount window, which effectively injects liquidity into the market. While the discount window is not significant most of the time, it sees a sharp increase during banking crises (such as the 2008 global financial crisis, the 2020 pandemic, and the 2023 regional banking crisis).

Currently, the usage of the discount window is relatively high ($7 billion), but it is far from historical "panic levels" and is not enough to have a significant impact on the market. Most of the time, it is basically not worth considering—I believe this will also be the case in the third quarter of 2024. So we can temporarily ignore the discount window.

2. Bank Term Funding Program - Little Change

The Bank Term Funding Program (BTFP) is a bank rescue measure that the Federal Reserve urgently launched in March 2023.

During and after the regional banking crisis (e.g., the collapse of Silicon Valley Bank), banks borrowed about $165 billion from the BTFP, which was a form of liquidity injection at that time.

However, the BTFP was closed by the Federal Reserve in March 2024, and these loans need to be repaid within 12 months. When these loans are repaid, it will remove liquidity from the market.

I expect there will not be much change in the Bank Term Funding Program in the third quarter; if there is a change, it may be less than $20 billion. To simplify the analysis, we can also temporarily ignore this factor.

3. Balance Sheet - $75 Billion of Liquidity Withdrawal

The Federal Reserve is currently undergoing quantitative tightening (QT), which involves reducing its large balance sheet by selling its substantial holdings of U.S. government bonds and mortgage-backed securities (MBS). Quantitative tightening is a form of liquidity withdrawal because when these assets are sold by the Federal Reserve, they need to be absorbed by the market, and those funds could have been used elsewhere.

This is the easiest to predict, as it is essentially a systematic process. The Federal Reserve's balance sheet is expected to decrease by about $25 billion each month in the third quarter, resulting in a total liquidity withdrawal of $75 billion from quantitative tightening.

4. Treasury General Account - $100 Billion of Liquidity Withdrawal

The Treasury General Account (TGA) is the government's bank account at the Federal Reserve.

When cash is idle in the Treasury General Account, it is effectively "dormant" and withdrawn from the market, thus representing a form of liquidity withdrawal.

Conversely, when money in the Treasury General Account is spent, it re-enters the market, thereby injecting liquidity.

Currently, the balance of the Treasury General Account is about $750 billion. In the latest quarterly refinancing announcement, the Treasury expects the balance to reach $850 billion by the end of the third quarter. Let's tentatively trust the Treasury's forecast. This means that the Treasury General Account will further increase (withdraw liquidity from the market), expected to increase by about $100 billion. Therefore, combined with the $75 billion liquidity withdrawal from quantitative tightening (QT), the increase in the Treasury General Account will result in a total liquidity withdrawal of $175 billion.

5. Reverse Repos - $200 Billion to $400 Billion of Liquidity Injection

Reverse repos (RRP) are a tool used by the Federal Reserve where financial institutions park cash to earn a fixed return during the loose monetary era of 2020 and 2021. By the end of 2022, about $2.5 trillion was deposited in reverse repos. Since both reverse repos and U.S. Treasury bills (T-bills) are short-term assets with no credit risk, they are almost perfect substitutes.

To cover its massive deficit, the U.S. government has issued a large amount of T-bills over the past 18 months. The yield provided by T-bills is slightly higher than that of reverse repos, attracting about $2 trillion to withdraw from reverse repos to purchase newly issued T-bills [Chart 3]. This cash moves from the Federal Reserve's "frozen" state back to the money market, thus representing a liquidity injection.

However, reverse repos stopped withdrawing liquidity in the second quarter of 2024 [Chart 4] because the U.S. government temporarily halted the large issuance of T-bills. This slowdown can be seen in a chart from @dharmatrade [Chart 5]. The chart shows that the net issuance of T-bills in 2023 and early 2024 significantly exceeded historical levels, then turned negative in the second quarter of 2024.

But this temporary slowdown in T-bill issuance will end in the third quarter of 2024. As the government attempts to fill the "gap" of its massive deficit, a large amount of T-bills will be issued again. Due to this upcoming flood of T-bills, I expect $200 billion to $400 billion will be withdrawn from reverse repos in the third quarter (I know this range is quite broad), which will be a liquidity injection.

[Chart 3]

[Chart 4]

[Chart 5]

Therefore:

• $200 billion to $400 billion of liquidity injection ( reverse repos )

• $175 billion of liquidity withdrawal (quantitative tightening and Treasury General Account)

• Net liquidity injection is between $25 billion and $225 billion

Revisiting the Treasury General Account

Let's return to the Treasury General Account (TGA) once more. So far, our calculations indicate a net liquidity injection in the third quarter. But this is based on the assumption that the Treasury General Account balance will be $850 billion by the end of the third quarter.

I previously mentioned that these estimates of the Treasury General Account balance should not be taken too seriously. Since Janet Yellen took office as Treasury Secretary, the estimated values of the Treasury General Account have often been overstated (sometimes by a significant amount).

Therefore, it is possible that the Treasury General Account balance at the end of the third quarter could be below $850 billion.

We already have a range for net liquidity injection in the third quarter, assuming a Treasury General Account balance of $850 billion, between $25 billion and $225 billion. Any deviation below an $850 billion Treasury General Account balance will shift this range upward.

Forecast

Taking all factors into account, this is the possible range for net Federal Reserve liquidity by the end of the third quarter, with an added buffer in case the estimate of the Treasury General Account balance is wrong again:

One Last Point:

This analysis assumes that conditions will not change during the third quarter.

However, there are still low-probability events that could force the Federal Reserve to respond to certain issues in the financial system or unexpected black swan events. This could include reopening the Bank Term Funding Program (BTFP), initiating another similar rescue facility, halting quantitative tightening, restarting quantitative easing, or taking any other measures that could quickly inject more liquidity into the market.