Investment Comment
26th April 2024
Decoding the Liquidity Landscape
Economic data has been mixed of late. Weaker than expected headline economic growth data in the US, combined with subpar survey data contrasts with continued robust productivity growth. Early April saw equity market weakness (which saw the US market ease back around 5%) after unpalatable inflation data resulted in some hawkish comments from a Federal Reserve official about potentially not cutting interest rates in the US in 2024. In recent weeks, investors appear to be deliberating corporate earnings reports, which have generally been good, and markets appear to be finding short-term stability.
The FTSE 100 index has scaled new heights, further buoyed by a depreciated pound at a five-month low (a falling pound results in rising profits in the UK, as so much of UK corporate revenue (some 79%) is derived from non-UK activity).
The continued strength in US economic performance coincides with robust demand, raising concerns about overheating and further inflationary pressure. This situation necessitates a cautious approach to monetary policy changes by the Federal Reserve. Historically economists would focus on interest rates, but since 2008 and especially since Covid other levers in monetary policy play a role. Here, understanding the current liquidity situation is crucial.
US Liquidity, and the Fed's Policy Tool
At the onset of the pandemic, the Federal Reserve embarked on Quantitative Easing (QE) by purchasing large quantities of Treasury debt and mortgage-backed securities, significantly expanding its balance sheet. The balance sheet expanded from around $4 trillion in 2019 to around $9 trillion by the summer of Spring of 2022. The primary objective of this intervention was to stimulate aggregate demand in response to the significant decline in economic activity.
This shifted gears in June 2022 as the Fed initiated Quantitative Tightening (QT) to gradually reduce its balance sheet size. As of early 2024, this QT has shrunk the Federal Reserve balance sheet from ~$9 trillion to $7.7 trillion. Alongside higher interest rates, this contractionary balance sheet policy was in response to inflation running well above its 2% target.
Quantitative Easing and Tightening can be seen in the size of the Balance Sheet
Source: Artorius, Bloomberg
Despite QT and higher interest rates, monetary policy appears not to have been as effective in terms of reducing inflation as hoped, or forecast. For answers to this conundrum, we may have to go deeper inside the balance sheet of the Central Bank.
The RRP: A Liquidity Management Tool
The Reverse Repo Facility (RRP) is a tool utilised by the Federal Reserve to manage short-term interest rates and liquidity in the US financial system. The facility can be integral to controlling liquidity when there is a cash surplus in the system that can lead to inflation. The use of the RRP has significantly increased in recent years reflecting the Fed’s efforts to manage substantial excess reserves accumulated during past QE programs.
The US Federal Reserve update in March 2024 highlighted that despite ongoing QT, which should have seen liquidity come out of the system, the Federal Reserve actually added liquidity to the system. This phenomenon can be attributed to the decline in usage of the overnight RRP. A little like QE post-2008, monetary policy and its tools appear to be different from that seen before the 2007-9 Financial Crisis.
Therefore, whilst the Federal Reserve has been engaging in balance sheet reduction over the past year, the RRP facility has been simultaneously injecting liquidity into the system. The RRP has reduced from $2.3T to just $327B. This decline in RRP is effectively adding liquidity into the financial system, whilst at the same time QT is withdrawing liquidity.
Federal Reserve Reverse Repo Facility decline
Source: Artorius, Bloomberg
The Road Ahead
The sizeable amount of liquidity injected through the RRP while simultaneously engaging in QT raises concerns about the potential counteraction of the intended effects of monetary policy. This complex interplay between liquidity, balance sheet and interest rate policy necessitates close monitoring and careful navigation by the Federal Reserve to ensure continued economic stability.
Earnings and economics
US companies have begun their quarterly updates for earnings. Generally, updates have been in line or as expected. But given the importance of US technology companies to the fate of the equity market, their updates have taken outsized importance in investors’ minds.
This week revealed Q1 earnings, with the major tech stock Meta beating expectations by ~8% yet seeing a share price fall of over 15% following the announcement of spending plans. In contrast, Tesla reported earnings that missed expectations, but with an announced push into more affordable Electric Vehicle models the share price rallied. Last night we saw results from Microsoft and Alphabet (Google’s parent company). Both Microsoft and Alphabet delivered numbers that beat expectations, resulting in a positive end to the week. Next minds turn to Nvidia, which has carried all before it in terms of being a front runner in the Artificial Intelligence world, as it prepares to provide an update to investors.
The most recent US economic data has generally been more resilient than expected. So, it was a surprise when the economic growth release for Q1 came in weaker than expected. Together with higher-than-expected inflation, this has prompted a resetting of investor risk appetite and we have seen equities in the US ease back lower in the past few days. Higher bond yields and uncertainty of policy direction, especially when one looks at the different moving parts of the Federal Reserve Balance sheet, leaves us cautious towards risk.
Rachael Faint, Portfolio Analyst Gerard Lane, Chief Investment Officer
All expressions of opinion reflect the judgment of Artorius at 26th April 2024 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content. The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results. Nothing in this document is intended to be, or should be construed as, regulated advice. Artorius provides this document in good faith and for information purposes only. Reliance should not be placed on the information contained within this document when taking individual investments or strategic decisions. Artorius Wealth Management Limited is authorised and regulated by the Financial Conduct Authority. Artorius is a trading name of Artorius Wealth Management Limited.
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