Stock market operates like a giant, intricate machine, and pinning down its direction to just one or two reasons is simply impossible. But here’s the good news: if we break it down one piece at a time, we can start uncovering the deeper truths that drive it.
Table of Contents
A Liquidity Perspective on the U.S. Stock Market
1. Since June 2022, the Federal Reserve has been withdrawing $75-80 billion every month in U.S. Treasury bonds and mortgage-backed securities.
2. This is the opposite of quantitative easing (QE), which injects money into the economy. Instead, this policy—called quantitative tightening (QT)—removes liquidity.
3. As the Fed began withdrawing liquidity, signs of stress in the market appeared, leading the Fed to slow down the pace of QT.
4. Gradually reducing the scale of a process like this is called tapering.
5. Cutting back QE is known as QE tapering, while scaling back QT is referred to as QT tapering.
6. The Fed, which had been withdrawing $80 billion monthly, reduced its cuts by half.
7. The next stage after QT tapering is the complete termination of QT.
When Will QT End?
8. The Fed plans to stop QT when bank reserves reach a target level.
9. Bank reserves refer to the amount of money that banks are required to hold with the central bank.
Example : If the reserve requirement is 10%, a bank with $1 million in deposits must hold $100,000 at the central bank, leaving $900,000 available for loans.
10. The President of the New York Fed has suggested ending QT when reserves fall to about 9% of nominal GDP.
11. If reserves drop below 9%, the financial market could face significant problems, as seen in the past.
Different Opinions Within the Fed
12. Christopher Waller, a Fed Governor and potential successor to Jerome Powell, disagrees with the New York Fed President’s view.
13. Waller believes reverse repo (RRP) balances act as a buffer, and liquidity should be evaluated by looking at both reserves and RRP balances.
14. Reverse repo is when banks lend money to the Fed. If reverse repo balances decrease, bank reserves increase, creating a buffer.
15. Waller’s comment was hawkish, suggesting QT could continue for longer.
The Role of Reverse Repo in Liquidity
16. We’re not academics—we’re investors and market participants.
17. Let’s skip the difficult and complex details and focus on the key point: reverse repo (RRP) provides a liquidity buffer to the market.
18. Reverse repo (RRP) is when the Fed borrows money from financial institutions.
19. Typically, financial institutions borrow from the Fed (repo), but when the roles reverse, it’s called “reverse” repo.
20. The Fed isn’t borrowing because it lacks money.
21. Instead, it uses reverse repo to absorb excess liquidity in the market to control inflation.
22. If RRP balances increase, it means the Fed is actively pulling liquidity out of the market.
23. If RRP balances decrease, it indicates the Fed is supplying liquidity back into the market.
A Bathtub Analogy for Liquidity
24. Picture market liquidity as water in a bathtub.
25. Through QT, the Fed has been draining water (liquidity) from the bathtub to reduce the supply of money.
26. Even if QT slows down (QT tapering), the water level continues to drop, just at a slower pace.
27. There is a way to keep the water level stable while still draining it.
28. The Fed can slow down the draining while turning on the faucet to add fresh water.
29. If the Fed continues reducing RRP balances, it’s like adding water to the tub while still draining it—providing liquidity even during QT.
Tracking RRP Balances
30. It’s easy to check whether RRP balances are decreasing.
31. The New York Fed reports daily RRP balances, while the St. Louis Fed provides graphs for a clearer view.
32. You can find these updates at the provided links (Link : St. Louis Fed)
32. As of December 27, 2024, RRP balances were $2,687 billion.
33. RRP balances, which peaked at over $2.3 trillion last year, have been steadily declining since the summer of 2023, now standing at $2,687 billion.
35. In simpler terms, the Fed has been reducing RRP balances and injecting liquidity into the market since last summer.
Impact of RRP Balances on Markets
36. From the perspective of financial institutions(banks), declining RRP balances look different.
37. The RRP rate is tied to the lower bound of the Fed’s target rate.
38. Whether lending money to the Fed at the RRP rate is profitable depends on market conditions.
39. If banks find better opportunities, such as lending to corporations at higher rates, RRP balances will naturally decline.
40. When corporate funding demand increases or the stock market rises, banks have less reason to park funds in RRP.
41. As RRP balances fall, liquidity indirectly flows into the market, benefiting companies and the stock market.
The End of RRP Balances
42. This explains why declining RRP balances often align with rising S&P 500 levels.
43. But everything that begins must eventually end.
44. RRP balances are now down to just $2.7 trillion. (Few days ago it has been below 2 trillion)
45. There’s not much left to reduce, meaning one of the key sources of liquidity is running out.
46. This means that one of the forces driving stock market liquidity is losing momentum.
Preparing for QT’s End
47. As RRP balances are nearly depleted, the Fed might have to consider ending QT.
48. Dallas Fed President Lorie Logan has suggested slowing QT and eventually stopping it.
49. Even Logan stated that as RRP balances approach critically low levels, the Fed should slow down its balance sheet reductions and phase out the program to avoid sudden shocks.
The Bigger Picture
50. To fully understand Logan’s statement, it’s important to know her background.
51. Quantitative easing (QE) and quantitative tightening (QT) were first introduced under Ben Bernanke’s leadership at the Fed.
52. The New York Fed is responsible for implementing these balance sheet policies.
53. Before becoming Dallas Fed President, Logan was Vice President at the New York Fed, overseeing these policies directly.
54. She’s considered the Fed’s top expert on QE and QT.
55. Even Logan is now suggesting that QT may soon end.
What Comes Next?
56. Without major policy changes, such as ending QT, the depletion of RRP balances could trigger liquidity shocks in the market.
57. Liquidity isn’t just about quantity—it’s also about how quickly it flows.
58. The critical takeaway is that one of the main drivers of liquidity is reaching its limit.
Alphazen Insights
The stock market rises when there’s someone willing to pay a higher price. Behind that willingness is liquidity—a steady flow of money that fuels confidence and action. The real question is whether this liquidity can keep flowing.
Some might argue that former Treasury Secretary Janet Yellen set a carefully timed “financial time bomb” before leaving office, aligning it with Trump’s administration. However, her successor, a Wall Street expert in their own right, might be capable of defusing it. Whether you see this as a conspiracy theory or not, one thing is clear: the future of liquidity will shape the market’s fate.
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