A Massive Liquidity Illusion

Since the election we’ve heard the rally in stocks characterized as a “Trump Trade” or a “reflation” trade. We think there is a really important element missing from this analysis that could change very quickly over the next several weeks.

On March 16, 2017 (the day after the Federal Reserve is expected to raise interest rates for the third time) the US Federal debt ceiling comes back into law at $20.1 trillion. At the end of January, total federal debt was $19.93 trillion, and in real-time using US Debt Clock (http://www.usdebtclock.org/) it is $19.93 trillion.

In anticipation of the debt ceiling coming back into force, since November, US Treasury deposits held at the Fed have dropped from over $400 billion to around $175 billion, unleashing over $200 billion of liquidity into the markets. In the chart below, one can see how US stocks leapt one week after the peak in US Treasury deposits at the FRB.

This has served to create the appearance that the Federal Reserve has been easing lately. Since 2014, the Fed has been slowly starting to reign in monetary accommodation. First it was by tapering, then in December 2015, the Fed began its current rate hiking cycle. Now, the Fed is still using the federal funds rate as the reference rate for monetary policy. This means that in order to lift the fed funds rate, the Fed needs to trim excess reserves in the banking system.