Liquidity & Markets

Understanding liquidity and how it interacts with markets

It’s going to be a tough year for markets and banks in 2023 as the Fed intends to drain liquidity at a rapid pace this year. Even though the pace might be affable now and possibly for the next few months, it won’t be long before the markets start to feel the effects. As the central bank responds to inflation by tightening the monetary stance and shrinking their balance sheet, the potential consequences for ongoing draining by central banks of reserves will likely be an important input into policy making. Knowing when this liquidity push is likely to run its course will help determine how to interact with the markets. 

In this piece, we will provide the following coverage points:

• Clarify what “liquidity” is

• Go over the dynamics of liquidity in 2023

• Gauge how they will correspond with each other   

Clarify what “liquidity is”:

Liquidity is simply the bank reserves. Bank reserves are money for banks. They are used to transact with each other and with the Federal Reserve. Sufficient reserves help banks provide liquidity to financial markets. 

Let's explain how:

A bank holding excess reserves in such an environment will seek to absorb high quality bonds, treasuries and mortgage-backed securities (MBS) and bid.  Also, banks will lend out those excess reserves at any positive interest rate, and this additional lending will decrease the short-term interest rate. With decreasing rates, investors tend to take more risks.

In 2023 there will be a lot going on with bank reserves. Why is this? Because of quantitative tightening. To understand quantitative tightening lets first dive into quantitative easing. 

Quantitative easing (QE) refers to the Federal Reserve’s purchases of large quantities of Treasury securities and mortgage-backed securities issued by government-sponsored enterprises and federal agencies to achieve its monetary policy objectives. The Federal Reserve used quantitative easing in response to the two most recent recessions—the 2007–2009 recession and the 2020 recession. In both instances, the Federal Reserve purchased large amounts of Treasury securities and MBSs issued by government-sponsored enterprises and federal agencies.The central bank purchased those assets by creating bank reserves as liabilities. Buying these securities adds new money to the economy, and also serves to lower interest rates by bidding up fixed-income securities.

Once monetary stimulus is no longer needed, the Federal Reserve can contract its balance sheet in a process called quantitative tightening (QT). In simple terms QT shrinks the Federal Reserve's balance sheet by letting the bonds it has purchased reach maturity and run off, therefore reducing the supply of bank reserves. 

To dive in deeper… the Treasury Department “pays” the Fed at the maturity of the bond by subtracting the sum from the cash balance it keeps on deposit with the Fed. To meet its ongoing spending obligations, the Treasury needs to replenish that cash by selling new bonds. When banks buy those bonds, they reduce their reserves. 

As can be seen via the chart below, when bank reserves are high, typically the fed fund rate is low. When the fed fund rate rises, bank reserves will decrease. 

The Fed started quantitative tightening in June, capping the decline at $30 billion in Treasuries and $17.5 billion per month in agency mortgage-backed securities (MBS). The Fed has mentioned in past FOMC minutes that it will continue its path of quantitative tightening and rate hikes. As the QT process takes money out of financial markets and rates rise, possibly incoming liquidity issues will warrant close monitoring over the current year.