Tag: Commercial Bank Reserves at the Fed

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Stocks and precious metals headed for a correction

Stocks are retreating across the board after climbing to dizzy heights in recent weeks. They continue to enjoy support, however, from falling Treasury yields and robust financial market liquidity. Support from crude oil is less certain, with a potential up-trend that could delay interest rate cuts.

Gold and silver are also retreating after strong gains in recent weeks. The correction appears to be a secondary movement. Base metals copper and aluminum are also weakening but the sell-off appears far stronger.

Stocks

Three out of seven mega-caps in the S&P 500 (Nvidia, Tesla, and Meta Platforms) show gains on Thursday, while four declined.

Top 7 Technology Stocks

The S&P 500 as a whole declined steeply, headed for a test of support at 5500.

S&P 500

The equal-weighted index ($IQX) took a similar pounding, breaking support at 6900. Retracement that respects the new resistance level would confirm a target of 6600.

S&P 500 Equal-Weighted Index

The retreat is across the board, with the Russell 2000 Small Cap ETF (IWM) [pink] falling faster than Russell 1000 Large Caps ETF (IWB) [blue] after spectacular gains earlier in the week.

Russell 1000 Large Cap ETF (IWB) & Russell 2000 Small Cap ETF (IWM),

Treasuries

Ten-year Treasury yields are retracing to test resistance at 4.2%. Respect is likely and would confirm our short-term target of 4.0%. Declining Trend Index peaks below zero continue to warn of downward pressure on yields. The low inflation outlook is bullish for bonds.

10-Year Treasury Yield

Financial Markets

Commercial bank reserves at the Fed finished largely unchanged for the week ended Wednesday, July 17, suggesting stable liquidity levels.

Commercial Bank Reserves at the Fed

Bitcoin is retracing to test support at $60K; respect would signal rising liquidity in financial markets.

Bitcoin

Labor Market

Initial claims climbed to 243K for the week ended July 13. This still well below levels normally seen leading up to a recession.

Initial Claims

Continued unemployment below 2.0m indicate a tight labor market.

Continued Claims

The Conference Board Leading Economic Indicator shows signs of a recovery after initially warning of a recession with a fall below -5.0%.

Conference Board Leading Economic Indicator

Dollar & Gold

The Dollar index reversed its sharp fall from Wednesday. Penetration of the descending trendline would warn of another test of 105 but we think this is unlikely considering the fall in Treasury yields.

Dollar Index

Gold retreated below support at $2,450 per ounce, indicating another test of $2,400. Respect of $2,400 would signal another attempt at $2,500, while breach would warn of a correction to $2,300.

Spot Gold

Silver followed through below $30, headed for a test of primary support at $29.

Spot Silver

Declining Trend Index peaks warn of medium-term selling pressure. But respect of support at $29 per ounce would suggest a target of $35 per ounce.

Spot Silver

Crude Oil

Nymex WTI crude steadied at close to $83 per barrel. Respect of resistance at $84 would be a strong bear signal.

Nymex WTI Crude

Brent crude is similarly testing resistance at $86 per barrel. Breach of support at $84 would be a strong bear signal.

Brent Crude

Base Metals

Copper broke support at $9,400 per metric ton. Expect retracement to test the new resistance level but respect is likely and would confirm the long-term target of $8,000.

Copper

Copper and aluminum track each other closely. The down-trend below has a likely target of $2,200 and is bearish for copper.

Aluminum

Conclusion

Stocks and precious metals appear headed for a much-needed correction after climbing to dizzy heights in recent weeks.

Of the three pillars, falling Treasury yields and robust financial market liquidity continue to support stocks. But crude oil is less certain, with a potential up-trend that would threaten higher inflation and could delay interest rate cuts.

Gold and silver are also retreating, after strong gains in recent weeks, in what appears to be a secondary correction. Support would provide a base for further gains.

But weakness in copper and aluminum is more concerning, signaling slowing demand from China which could easily trigger a global recession.

Acknowledgements

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The Fed, Treasury and liquidity

A reader asked me to please explain why liquidity is rising despite the Fed hiking rates and shrinking its balance sheet (QT) by more than $1.7 trillion.

We will try to avoid the technical jargon and stick to the basics. But it’s not always an easy concept to explain or grasp.

What is liquidity?

Liquidity is not the same as money. It is more closely related to other side of the balance sheet and is best described as the “ease of financing” or availability of credit in financial markets. It includes access to credit from the domestic banking system and bond markets, as well as international financial markets.

In Reminiscences of a Stock Operator Jesse Livermore describes the operation of the Money Post on the floor of the exchange, where brokers borrowed money overnight to finance their stock operations. We have included an excerpt where he describes the impact of tight liquidity leading up to the crash of 1907. It is worth reading: The Money Tree | Jesse Livermore

How do we measure liquidity?

We use several indicators to measure liquidity in financial markets. These include:

Commercial Bank Reserves at the Fed

Commercial bank reserves spiked up in March 2023 after the Silicon Valley Bank (SVB) debacle, when the Fed introduced the Bank Term Funding Program (BTFP). Reserves continued to climb steeply until February 2024, when inflation reared its head, before falling sharply in March and April during the tax payment season.

Commercial Bank Reserves at the Fed

Chicago Fed Financial Conditions Index

The Chicago Fed Financial Conditions Index is an excellent measure of financial market liquidity, though data is normally a week behind that of bank reserves.

Chicago Fed Financial Conditions Index

Moody’s Baa Corporate Bond Spread

Moody’s Baa corporate bond spreads are a good indicator of credit availability in bond markets. The spread measures the premium that low investment grade corporate borrowers have to pay over the risk-free Treasury rate.

Moody's Baa Corporate Bond Spreads

Bitcoin

We even use Bitcoin as the “canary in the coal mine”. Cryptocurrencies are the most liquidity-sensitive assets in financial markets and normally the first to show signs of stress.

Bitcoin climbed steeply from November ’23 until early March ’24 before stalling in March-April. Its rise in May heralded a recovery in financial market liquidity.

Bitcoin

How the Fed and Treasury influence liquidity

The most obvious way that the Fed influences liquidity is by purchasing or selling Treasury and Agency securities in financial markets.

In April 2020, the Fed purchased almost $3 trillion in securities, expanding its balance sheet (blue below). We can also see that Treasury took advantage of these Fed purchases, issuing $1.4 trillion more in securities than it needed to fund current expenditure. The surplus shows in the TGA account at the Fed (red below) and had the effect of partially offsetting the Fed’s injection of liquidity.

Chicago Fed Financial Conditions Index

In 2021, Treasury slowed their issuance of securities, as they neared the debt ceiling, and started to draw down on their TGA account at the Fed (red above). This amplified Fed QE (blue) as it also injected liquidity into financial markets. The Fed did their best to offset this by borrowing in financial markets through overnight reverse repo operations (green above) mainly from money market funds which normally invest in T-Bills and other short-dated securities.

In late 2022, the Fed announced it was going to gradually reduce its balance sheet as securities matured. The blue area below zero is referred to as quantitative tightening, or “QT”. Since then, total assets at the Fed have shrunk by roughly $1.7 trillion. Treasury also increased net issuance and started to rebuild their TGA account balance (red) above. But the Fed was again able to offset this by lowering rates offered on reverse repo and running its RRP liabilities (green) down from almost $2.4 trillion to just $371 billion at present.

The net impact of the combined operations is shown by the blue line below. The massive combined monetary easing lasted until early 2022, when tightening commenced. But tightening ended after the March ’23 banking (SVB) crisis, with the Fed injecting liquidity to prop up financial markets until March ’24. By March, inflation was starting to rebound and the Fed may have realized that they had over-egged the pudding.

Chicago Fed Financial Conditions Index

The abrupt fall in liquidity in March-April was evident not only in bank reserves but in Bitcoin and in the stock market.

Conclusion

Liquidity is again rising — as shown by the the rise in Bitcoin and the fall in Chicago Fed Financial Conditions Index. Stocks and bonds are likely to rise as a result.

Notes

There are further factors that affect financial market liquidity in the US. This can include monetary easing by foreign central banks. The PBOC may inject liquidity into financial markets in Beijing or Hong Kong but the net result may ease financial conditions in New York if US T-Bills offer higher rates of return than the equivalent security in China.

We have also seen Treasury Secretary Janet Yellen change the mix of Treasury issuance in order to reduce the impact on financial market liquidity. Reducing the amount of longer maturity Treasury notes and bonds and increasing issuance of shorter-term T-Bills also helped to boost liquidity. T-Bills are the most liquid asset on the planet, with almost infinite demand. Holding a 3-month T-Bill is like holding Dollars — they have no default or rate risk — but you get a 5.0% return on top. So issuing more T-Bills has limited impact on short-term rates, while issuing less 10-year Notes , for example, will lower long-term yields when demand exceeds supply.

Acknowledgements

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S&P 500 retreats, along with crude and precious metals

Treasury yields are trending upwards, as inflation proves persistent, but also driven by the scarcity of foreign buyers in the UST market. Rising Japanese long-term yields, the result of a weak Yen and higher inflation, make Treasuries less attractive to Japanese institutional investors. Geopolitical tensions have also motivated the BRICS, led by China, and the Saudis, to reduce exposure to the Dollar and increase their gold reserves.

10-Year Treasury yields are retracing to test support at 4.5%. Rising Trend Index troughs indicate upward pressure and respect of support would confirm another test of 4.7%.

10-Year Treasury Yield

Liquidity in financial markets is improving, however, with commercial bank reserves restoring almost half of the amount lost during the April tax payment season.

Commercial Bank Reserves at the Fed

Stocks

The S&P 500 is undergoing a retracement, likely to test support at 5200. Declining Trend Index peaks warn of secondary selling pressure, with the strong primary up-trend unlikely to be threatened.

S&P 500

The equal-weighted S&P 500 fared slightly better, finding short-term support at 6600. But a steeper Trend Index decline warns of stronger selling pressure. Breach of 6600 would warn of a test of primary support at 6450.

S&P 500 Equal-Weighted Index

Gold and the Dollar

The Dollar index twice respected resistance at 105 and another test of the key 104 level is likely. Breach of 104 and the rising trendline would warn of a reversal to test the band of primary support (red) between 100 and 101.

Dollar Index

Gold made a weak recovery above support at $2330 per ounce. The Trend Index warns of significant selling pressure and another test of primary support at $2280 is likely. Domestic Chinese demand remains strong, however, with the Shanghai Gold Exchange Au99.99 contract trading at an equivalent of $2373 per ounce.

Spot Gold

Silver also shows selling pressure, with a lower peak on the Trend Index. Another test of support at $30 per ounce is likely.

Spot Silver

Crude Oil

Nymex light crude is again testing support at $78 per barrel after a strong inventory build reported by the EIA. Follow-through below $77 would signal another decline, with a likely test of primary support at $68.

Nymex Light Crude

Crude oil and petroleum inventories are rebuilding after a decline in early 2024.

Crude Oil & Refined Petroleum Products Inventory

The managed money short position in Brent Crude futures is at its highest level since 2020, suggesting a bearish outlook for crude oil. But beware of a surprise OPEC+ production cut in the lead-up to the November US elections.

Crude Oil Short Positions

Conclusion

The key variable in our short-term outlook is financial market liquidity. That is improving and should support stock prices.

In the long-term, lower crude oil prices are expected to ease inflationary pressures and allow the Fed to maintain easy monetary policies. But the Treasury market is susceptible to selling by foreign investors — which should maintain upward pressure on long-term yields.

Lower inflation and higher long-term yields are bearish for precious metals. But these are outweighed by increased central bank buying due to geopolitical tensions and collapse of the Chinese real estate market. This has left domestic investors shifting to Gold as an alternative store of value.

We remain short-term bullish on stocks. Long-term, we prefer critical materials needed for the energy transition — especially lithium, copper and uranium; heavy electrical industry; and defensive sectors with strong dividends.

Acknowledgements

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S&P 500 storm in a teacup

Markets were spooked by “hawkish” comments in the latest FOMC minutes, where some participants indicated a willingness to tighten policy should such action become appropriate:

Participants discussed maintaining the current restrictive policy stance for longer should inflation not show signs of moving sustainably toward 2 percent or reducing policy restraint in the event of an unexpected weakening in labor market conditions. Various participants mentioned a willingness to tighten policy further should risks to inflation materialize in a way that such an action became appropriate. ~ Minutes of the Federal Open Market Committee: April 30–May 1, 2024

This is nothing new: all FOMC members should be prepared to hike rates if inflation spikes to the point where tighter policy is appropriate. What seems to have spooked markets is the fact that it was considered appropriate to discuss this out in the open.

10-year Treasury yields rallied to test 4.5%, ending the series of declining Trend Index peaks. Breakout above 4.5% would signal another test of 4.7% but breach of support remains likely and would signal a decline to test support between 4.0% and 4.1%.

10-year Treasury Yield

The large engulfing candle on the S&P 500 is a bearish sign. Expect a test of support at 5200 but respect is likely and would confirm our target of 5500.

S&P 500

The S&P 500 Equal-Weighted Index ($IQX) retreated sharply and is likely to test support at 6600.

S&P 500 Equal-Weighted Index ($IQX)

Financial Markets

Commercial bank reserves at the Fed climbed to $3.39 trillion on May 22, continuing the recovery of financial market liquidity after the sharp fall during April tax payment season.

Commercial Bank Reserves at the Fed

The inverted Chicago Fed Financial Conditions Index (black below) continues to climb, indicating easier monetary policy. The S&P 500 (blue) is expected to follow the FCI upwards.

S&P 500 Index & Chicago Fed Financial Conditions Index (inverted scale)

Wicksell Analysis

The chart below is based on the theory of interest and money published by Swedish economist Knut Wicksell in 1898. Monetary policy is restrictive when long-term interest rates are higher than nominal GDP growth (the marginal return on new investment) and stimulatory when LT rates are below nominal GDP growth.

We plot nominal GDP (silver) against 10-year Treasury yields (purple) below. Stimulatory monetary policy is evident in the 1960s and ’70s — with GDP growth (silver) above long-term rates (purple) — boosting growth and inflation. This followed by restrictive policies in the 1980s and ’90s before long-term rates were again suppressed to stimulate the economy in the last two decades.

10-year Treasury Yield & Nominal GDP Growth

Nominal GDP grew at an annualized rate of 5.5% in Q1 of 2024, while the 10-year yield is below 4.5%, indicating that monetary policy remains stimulatory. Further growth and inflation are likely.

Crude Oil

The counter-argument to the monetarist view is that crude oil prices are falling and likely to ease inflationary pressures in the economy.

Nymex light crude broke support at $78 per barrel, indicating a decline to test long-term support (red) at $68.

Nymex WTI Light Crude

Energy prices were the primary cause of the spike in CPI in 2021 and its subsequent fall in 2022-23.

Conclusion

Crude prices are likely to fall, easing inflationary pressures and leading to lower long-term interest rates.

We expect the Fed and US Treasury to maintain easy monetary conditions until after the November elections.

The current bull market in stocks is likely to continue until end of the year.

Ceteris paribus

The Latin phrase ceteris paribus means “all else being equal.”

If Vladimir Putin and Xi Jinping attempt to influence US elections by disrupting the global economy — through cyberattacks, damage to undersea communication cables, infrastructure, or transport bottlenecks — then all bets are off and we could be in for a wild ride.

Acknowledgements



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