Will the US liquidity base revive risky assets? Bitcoin, Ethereum and stock indices?

It's no secret that financial markets depend on liquidity like a drip. The higher the liquidity and the greater the available capital and collateral, the greater the tendency for financial institutions to bear risk. The simplest exercise to demonstrate this is to look at the difference in the Fed's balance sheet and the scale of the decline in reverse repo excess liquidity.

The Fed is limiting liquidity through QT to the amount of USD 95 billion per month, although there are ongoing discussions to reduce this reduction of the balance, and reverse repo, in turn, adds liquidity in an incomparably greater way than QT draws it down. As a result, net liquidity, in the form of bank reserves with the Fed, is systematically increasing.

Markets hostage to liquidity - stock indices, cryptocurrencies

Since January 2022, it appears that markets have become hostage to the increase or decrease in reserves, i.e. they have become hostage to the liquidity in the system. Moreover, the correlation between the SPX index and WRESBAL (Liabilities and Capital: Other Factors Affecting Reserve Balances: Reserve Balances in Banks Federal Reserve) is greater for the annual change in reserves than their balance itself.

As of January 2022, the correlation coefficient of change in reserves with SPX is 0,84. This is much higher than WRESBAL itself with SPX, which is 0,62.

However, based on WRESBAL alone, we can try to estimate when the addition of liquidity will start and when the year-on-year growth will end. We are talking about the base effect from the previous year, which we use in the same way as the base for calculating inflation from the price index.

The negative base ends this week. Will this be a good time for risky assets?

The first base effect will occur at the end of the second decade of January, and the second will occur at the end of the first week of March 2024. This means that adding liquidity in USD on an annual basis should have the largest effect between the third decade of January and the first week of March. Then, in theory, risky assets may get a tailwind, which is quite important due to the increasing liquidity in the US banking system. This assumption will be correct when excess liquidity from reverse repo continues to decline, where it is said that from the current over USD 600 billion it may drop to USD 400 billion in the near future.

Cryptocurrencies and stock indices

From the above, it may follow that if the correlation continues to hold, risky assets, including Bitcoin, Ethereum, or American stock indices, may soon begin a systematic upward movement after the New Year's correction. Also, the situation with BTC ETFs may be of secondary importance at this point. In fact, a lower price may encourage greater involvement in the following weeks. This is quite an interesting test for the markets as to whether liquidity will continue to grow and, if so, whether 84% of it will still be reflected in the prices of risky assets by March.