Highflying U.S. stocks could be headed for an uncomfortable descent as the wash of central-bank liquidity that has given equity markets a boost this year begins to ebb, according to one longtime Wall Street strategist.
A few months ago, Citigroup strategist Matt King published a note to clients highlighting a $1 trillion injection of central-bank liquidity, engineered primarily by the People’s Bank of China, along with the Bank of Japan, European Central Bank, and the Federal Reserve which he said helped to explain the strength in U.S. equity prices this year.
In a follow-up recently shared with Citi’s clients, King explained how the Federal Reserve’s efforts to support the U.S. banking system following the collapse of Silicon Valley Bank added even more fuel to the central-bank liquidity fire, but now that impact is beginning to wane.
The end result could remove one of the most reliable pillars of support for equities, which have so far defied a spate of threats, including waning corporate profits, recession fears, and signs that inflation isn’t coming down as quickly as some economists had expected.
All told, the Federal Reserve’s support for banks via the discount window and an emergency-lending program, coupled with drawdowns in the U.S. Treasury General Account earlier this year as taxpayers received their refunds, have added some $440 billion in liquidity support for stocks in the span of little over a month.
The result of this was behavior in markets that seemed distinctly “QE-like,” King said, referring to the Federal Reserve’s quantitative easing program, unleashed during the aftermath of the 2008 financial crisis, which has been credited with helping drive stocks higher during a 10-year bull market.
Since the start of 2023, daily action in stocks has been reminiscent of the days when a Fed-led global quantitative easing dominated markets, King said during a phone interview with MarketWatch.
“In many respects, the price action feels QE-like, in particular the low levels of daily volatility in equities,” King said. “I think there is a very good reason for that.”
However, in recent weeks, the size of these programs has started to decline, while the Fed’s balance sheet has continued to shrink.
As King explains, calculating the size of reserves held at the Federal Reserve is more complicated than just looking at the amount of bonds held on its balance sheet.
The Fed’s emergency lending to banks through the discount window and the Bank Term Funding Program cause Fed reserves to swell. Meanwhile, on the other side of the ledger, changes in the size of the Treasury General Account and the Fed’s overnight reverse-repo facility cause reserves to shrink since they are liabilities, not assets.
U.S. stocks retreated from near their highest levels of the year late last month just as the central-bank liquidity impulse was starting to fade, King noted.
Over the past week, the S&P 500 index has shed roughly 50 points, although it remains mired in an increasingly tight trading range. Whether more weakness lies ahead remains to be seen, but according to King, changes in the amount of liquidity central banks are pushing out into the economy is perhaps the best explanation for the behavior of stocks since the start of the year — even if it works with a short lag.
“I think it fits the price action better than anything else, and if it is right, it takes you to a very different place in terms of where we go from here,” he said.
All three major U.S. indexes were trading in the red on Tuesday, with the S&P 500
SPX
off 0.3% at 4,124, while the Nasdaq Composite
COMP
was down 0.5% at 12,196. The Dow Jones Industrial Average
DJIA
was off by 24 points, or 0.1%, at 33,592.
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