Too Much Cash – Why Abundant Liquidity May Hurt The Markets

Excess liquidity caused by low-interest rates is backfiring. Banks are hurriedly flooding the FED with cash. Are investors ignoring the warning signs?

Alive Once Again

With negativity coming from all corners, Mr. Market would like to make you believe that the USD Index is heading back to 75. However, after bouncing above 90 on May 26, the greenback remains undervalued and likely has plenty of room to run. Case in point: I highlighted on May 25/26 that the U.S. Federal Reserve’s (FED) daily reverse repo transactions are mirroring the volatility that we witnessed in December 2015. And while investors have ignored the unsettling behavior, with sold repos’ value spiking above $450 billion on May 26, the USD Index may be sensing that something is amiss.

Please see below:

A reverse repurchase agreement (repo) occurs when an institution offloads cash to the FED in exchange for a Treasury security (on overnight or short-term basis). And with U.S. financial institutions currently flooded with excess liquidity, they’re shipping cash to the FED at an alarming rate.

The green line above tracks the daily reverse repo transactions executed by the FED, while the red line above tracks the federal funds rate. Moreover, notice what happened the last time reverse repos moved above 400 billion? If you focus your attention on the red line, you can see that after the $400 billion level was breached in December 2015, the FED’s rate-hike cycle began. Thus, with current inflation dwarfing 2015 levels and U.S. banks practically throwing cash at the FED, is this time really different?

To that point, while it may not be visible on the surface, global central banks are already tightening financial conditions. Following in the footsteps of the Bank of Canada (BOC), the Reserve Bank of New Zealand (RBNZ) announced on May 26 that “we believe it is appropriate to return to our long-standing practice of publishing an OCR projection.” And while the RBNZ labeled its forecast as “conditional” and subject to “the economic outlook,” it’s clear that we’re past the point of peak liquidity.

Please see below:

To explain, the blue line above tracks the RBNZ’s Official Cash Rate (OCR). If you analyze the right side of the chart, you can see that the central bank is already projecting liftoff by mid-2022. However, with most central banks initially expecting to hold off until sometime in 2023, if rampant inflation persists, another revision could happen sooner rather than later.

Shadow Rates

Case in point: “shadow rates” signal that a major shift is already underway. To explain, economists normally use the federal funds rate to construct their economic models. However, after the initiation of quantitative easing (QE) sent some overnight lending rates below zero (like the European Central Bank’s), shadow rates became a substitute for the federal funds rate. For example, when Jing Cynthia Wu and Fan Dora Xia created the metric, the relationship meant that when the FED increased its asset purchases by 1%, the shadow rate decreased by 0.0183%. More importantly, though, with the script now flipped, reduced liquidity is leading to a rise in global shadow rates.

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Disclaimer: All essays, research and information found on the Website represent the analyses and opinions of Mr. Radomski and Sunshine Profits' associates only. As such, it may prove wrong ...

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