The US Federal Reserve (FED) recently launched an attempt to cut its $8.9 trillion balance sheet by halting billions of dollars in Treasury and bond purchases. The measures were implemented in June 2022 and coincided with the total market capitalization of cryptocurrencies dropping below $1.2 trillion, the lowest level seen since January 2021.
A similar movement occurred for the Russell 2000, which reached 1,650 points on June 16, a level not seen since November 2020. Since this drop, the index has risen by 16.5%, while the total market capitalization of cryptocurrencies has not been able to recover the level of $1.2 trillion. . .
This apparent disconnect between the cryptocurrency and stock markets has led investors to question whether the Fed’s growing balance sheet could lead to a longer-than-expected crypto winter.
The Fed will do whatever it takes to fight inflation
To tame the economic downturn caused by restrictive measures imposed by the government during the COVID-19 pandemic, the Federal Reserve added $4.7 trillion to bonds and mortgage-backed securities from January 2020 to February 2022.
The unexpected result of these efforts was a 40-year high inflation and in June, US consumer prices jumped 9.1% versus 2021. On July 13, President Joe Biden said inflation data for June was “unacceptably high.” Furthermore, Federal Reserve Chairman Jerome Powell stated on July 27:
“It is imperative that we bring inflation down to our 2 percent target if we are to have a sustainable period of strong labor market conditions that benefit everyone.”
This is the main reason that prompted the central bank to withdraw its stimulus activities at an unprecedented speed.
Financial institutions have an abundance of cash problem
A “repurchase agreement,” or repo, is a short-term transaction with a repurchase guarantee. Similar to a secured loan, the borrower sells the securities for an overnight financing rate under this contractual arrangement.
In a “reverse repo,” market participants lend cash to the US Federal Reserve in exchange for US Treasury securities and agency-backed securities. The lending side consists of hedge funds, financial institutions, and pension funds.
If these money managers are unwilling to allocate capital to lending products or even extend credit to counterparties, having a lot of cash at disposal is not inherently positive because they must provide returns to depositors.
Fed Overnight Reverse Repo Agreements, in US Dollars. Source: St. Louis FED
On July 29, the Federal Reserve’s Reverse Repo Facility reached $2.3 trillion, approaching an all-time high. However, holding that much cash in short-term fixed income assets will bleed long-term investors given the current high inflation. The only possible thing is that this excessive liquidity will eventually transfer to risk markets and assets.
While a record high demand for cash may indicate a lack of confidence in counterparty credit or even a stagnant economy, for risky assets there is potential for increased inflow.
Certainly, if one thinks that the economy will collapse, cryptocurrencies and volatile assets are the last places on earth to seek shelter. However, at some point, these investors will not incur further losses by relying on short-term debt instruments that do not cover inflation.
Think of a reverse repo as a “security tax”, a loss for someone willing to take on the lowest possible risk – the Federal Reserve. At some point, investors will regain confidence in the economy, which will positively affect risky assets or they will no longer accept returns below the inflation level.
In short, all that cash is waiting on the sidelines for an entry point, be it real estate, bonds, stocks, currencies, commodities or crypto. Unless hyperinflation magically disappears, a portion of that $2.3 trillion will eventually flow into other assets.
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