From Real Investment Advice, March 5:
Many believe Winston Churchill coined the phrase: “Never let a good crisis go to waste.” Others think it was President Obama’s Chief of Staff, Rahm Emanual, who said, “You never want to let a serious crisis go to waste” during the financial crisis. Regardless of who first spoke those words and whether the crisis is “good” or “serious,” the Fed may be planning on heeding their crisis advice.
On February 19, 2025, the Fed made a confounding statement about QT, aka balance sheet reduction. Per its latest FOMC minutes: “several participants suggest halting or slowing balance sheet reduction pending debt ceiling resolution.”
If the government were to stop issuing debt because of a debt ceiling impasse, financial liquidity would increase as the Treasury would spend down its roughly $800 billion piggy bank known as the Treasury General Account (TGA). Due to its positive impact on liquidity, some people call a potential TGA withdrawal “Not QE, QE.”
Thus, if a government shutdown results in additional, albeit temporary, liquidity to the financial system, why halt or slow QT, which drains liquidity?
The timing of the Fed’s confounding statement aligns with an essential gauge of excess liquidity. Might the Fed be offering investors a liquidity warning cloaked as a reaction to a fiscal crisis?
To help answer the question, we review two popular liquidity gauges. In the postscript, following our summary, we share some measures of liquidity and reserves the Federal Reserve monitors.
What Is Water?
Before progressing, it is worth emphasizing how vital and underappreciated liquidity is to the financial markets. We lean on Chris Cole at Artemis Capital to help you appreciate liquidity.
In his piece, What Is Water In The Markets, Cole uses a commencement speech by David Foster Wallace to make an analogy between liquidity in the financial markets and water for a fish. Likely, fish don’t pay attention to the water that surrounds them. Similarly, how often do we think about the air we breathe?
Financial markets, like fish and humans, exist in a medium that sustains its being. Yet, despite the grave importance of liquidity, the market medium, few investors pay much attention to it. Without water, a fish will die. When liquidity fades, volatility often spikes, and market fragilities are exposed. Thus, measuring liquidity, the medium investors struggle to quantify and rarely discuss, is warranted.
The Roots Of The Current Liquidity Omen
In the pandemic crisis of March 2020, the Federal Reserve and the government opened the liquidity floodgates to combat the shuttering of the global economy. As we share in the first graph below, courtesy of Longtermtrends, in 2020, the percentage growth of M2 money supply (black) grew at a higher rate than at any time in history. The second graph shows that deficit spending as a percentage of GDP was 15% in 2020. The only time since 1930 it was higher was during World War II.
The covid crisis shut down the global economy and sent financial markets plummeting. Liquidity fled the markets, and significant volatility ensued. Consequently, the Fed and government did everything possible to restore economic and market liquidity.
What is now most important to grasp is how much of that extra liquidity still exists. One big clue is the Fed’s Reverse Repurchase Program (RRP).
Reverse Repurchase Program (RRP)
Had the Fed not managed excess liquidity, its monetary policy in 2020 and 2021 would have sent short-term interest rates well into negative territory. The Fed’s RRP was employed to soak up the extra liquidity.
The program allows banks and money markets to lend money to the Fed, and in exchange, the Fed provides them with risk-free Treasury collateral. The “risk-free” money market surrogate effectively met the massive demand for short-term investments and kept rates positive.
We should consider the RRP balance as the financial market’s excess liquidity. The liquidity warning we allude to in the opening is the current negligible RRP balance. As shown below, the once $2.55 trillion storer of excess liquidity has dwindled to near zero. While liquidity may not be an issue today, there is no longer a massive bank of liquidity for the market to draw on.
With RRP largely evaporated, tracking liquidity becomes much more critical.
Market Monitors of Liquidity
One of the more straightforward gauges of liquidity is the sum of the RRP balances and bank reserves held at the Fed. Bank reserves approximate the potential liquidity banks could provide.
As the data below shows, liquidity, using this measure, is steadily declining. However, it is still well above pre-pandemic levels. The question worth asking but lacking an answer is how much more liquidity our economy and markets require today than before the pandemic....
....MUCH MORE (chart mania)
We linked to Chris Cole's "What is Water" piece under the headline "Volatility Mavens Artemis Capital Management | Letter to Investors | July 2018" along with:
....Previous visits to Artemis:
October 2017
"Will Short Volatility Trigger the Next Black Monday?"
August 2017
"Volatility and the Prisoners Dilemma"—CBOE Risk Management Conference Asia, December 1, 2015
And many more, use the search blog box keywords 'Cole, Artemis' if interested.
(just using 'Artemis' will get you a hundred posts on reinsurance and cat bonds, worthy but not related, directly)
Baby Got Black (Swan)Genius or madman?
(With apologies to Sir Mix-a-Lot)
I like… fat… tails and I cannot lie
You vol sellers can’t deny
When a hot trend breaks with a well-timed stop
and a great big black swan pop you get
Paid… P&L year gets made
‘Cause you noticed that trade was packed
Buncha mean reversion suckers got jacked
Oh baby I wanna get lumpy
Long gamma for when it gets bumpy
Central banks tried to haze me,
But those carry trades just don’t faze me!...MORE
