Market Rallies Mask Liquidity Tightening Beneath the Surface
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On November 28, paid members received an update highlighting why liquidity remains tight, volatility tailwinds may be exhausted, and oil and inflation swaps are starting to turn higher.
Takeaways
Funding markets tightened sharply, suggesting elevated risk around upcoming large Treasury settlement dates.
Volatility selling dominated the short holiday week.
Rising repo facility usage and elevated overnight collateral rates point to potential equity pressure if liquidity strains persist.
Observations
The video highlights a week where aggressive volatility selling overshadowed expected equity weakness from Treasury settlement pressures. Liquidity conditions tightened meaningfully, with repo rates rising and increased usage of the Standing Repo Facility signaling stress. The equity markets may face renewed downside pressures.
Fully Edited Transcript by ChatGPT
Last week’s analysis has not gone according to plan, and the video itself has not aged well. At the end of that video, I wondered whether calling attention to this pattern might stop it from working—and now I find myself wondering whether I should have avoided discussing it publicly, because it really was a useful signal while it lasted.
The main issue is that most of the meaningful Treasury settlements were scheduled for Friday and the upcoming Monday, December 1, which has not occurred yet. The settlement we saw on Tuesday was relatively small at only $14 billion. It’s possible that this was simply not a large enough amount to matter, although in the prior week we observed similarly sized settlements and the market declined notably. It’s therefore difficult to determine exactly what happened.
Looking at the week’s price action, the market showed many characteristics of volatility selling during a shortened holiday week. What made this week particularly interesting was the sharp drop early Tuesday morning—almost exactly as I would have expected—which may have flushed out some early selling. The market fell nearly 70 basis points within the first ten minutes of trading before quickly rebounding, and from that point forward, volatility selling dominated the session.
Wednesday was not a settlement date, so there was no reason to expect downside that day. Friday was a settlement date, but despite that, the market climbed higher—although most of the move came in the final minutes of trading. Around 12:40 p.m., the market was up only 25–30 basis points, which is typical for a settlement day, before pushing higher into the close.
Stepping back, this week featured only three and a half trading days, which makes it an ideal environment for volatility selling. The VIX fell sharply—from about 26.4 on Thursday the 20th to just 16 by Friday. Even comparing Friday closes, it fell from 23.5 on the 21st to 16.3 a week later. This marked one of the largest five-day percentage declines in the VIX since 2020, with only a handful of similar episodes. That gives you a sense of how intense the volatility selling was.
Another notable point: while the VIX made a lower low, the S&P 500 closed essentially unchanged relative to its level on November 12. The VIX closed at 17.5 on that day, compared with 16.3 this week, yet the S&P is at the same price. This underscores how outsized the volatility selling has been.
Other cross-asset indicators confirm this. Three-month implied correlations fell; one-month implied correlations fell; and dispersion also fell. Typically, when implied correlations decline, dispersion rises—but that did not happen. Both the VIX and the VIX constituent volatility index fell meaningfully. Volatility declined across the board, but index-level volatility fell more sharply than constituent-level volatility. Even though dispersion fell, the index VIX fell faster.
When looking at dispersion minus three-month implied correlation, the spread rose into Tuesday and then declined Wednesday and Thursday. The S&P 500 typically trades in line with this spread. Liquidity also tightened considerably last week, making the week’s upside even more surprising and reinforcing the idea that Friday’s rally does not necessarily invalidate the liquidity-strain thesis.
On Friday, the overnight general collateral repo rate rose to 4.09%, the highest level since early November, when rates eased following month-end. This implies that SOFR will likely print higher on Monday. It’s also possible that overnight funding costs remain high on Monday due to the upcoming $80–85 billion settlement.
We also saw the Standing Repo Facility used again on Friday, with about $24.5 billion borrowed. This likely means usage will rise again on Monday. Importantly, the Standing Repo Facility is not the Fed injecting liquidity willingly. Institutions go to the facility because they lack cash but have acceptable collateral; they provide collateral to the Fed in exchange for cash and pay interest on that borrowing. It is the opposite of the Reverse Repo Facility, where institutions voluntarily park excess cash at the Fed in exchange for collateral and interest.
So the idea that the Fed is “saving the market” by injecting liquidity is misguided. Institutions are simply choosing to borrow from the Fed at around 4.0% rather than borrowing in the market at 4.09%. The facility exists to keep repo rates contained and avoid a repeat of the September 2019 funding spike.
Given this backdrop, it is quite possible that repo facility usage rises due to liquidity needs tied to Treasury settlements.
More broadly, overnight funding conditions have tightened significantly relative to earlier in the week. I expect the next two days to be particularly strained. I would not dismiss the idea that Treasury settlement dates are affecting markets. I think they are having a real impact, especially in funding markets, although last week’s holiday-driven volatility selling may have masked the expected equity impact. By the end of the coming week, we should have clearer evidence.
The Treasury General Account (TGA) remains around $900 billion—down from just over $1 trillion on November 30—but that $100 billion drop has only modestly eased reserve pressure. Reserves are still around $2.9 trillion and are unlikely to rise meaningfully unless the TGA declines further, especially since QT has effectively ended and the reverse repo facility has already drained.
There is also a balance-sheet category labeled “Other,” which is not well defined but represents a significant amount. It has risen from about $158 billion to $223 billion and appears to have shifted upward starting in February. It likely includes government-sponsored entities and other institutions. If this category were to decline, it could free up reserves, but it has been trending higher and is unpredictable.
Finally, I noted in the Advanced Topics group that DTC transaction volume has increased over the last few days, which aligns with settlement activity. There appears to be some relationship between DTC volume changes and movements in the S&P 500. Historically, spikes in DTC activity often coincide with S&P declines. It is not a perfect relationship, but the patterns suggest a slight lag between funding-market frictions and equity market reactions—possibly tied to equity-repo financing, which declined in the week of the 19th.
Overall, I still believe Treasury settlement dates matter. Last week’s dynamics may have been overridden by holiday-week volatility selling and prior low-volume tailwinds. I’m not entirely certain yet, but I plan to give it a couple more days to see whether Treasury settlements are affecting equity prices. They are clearly affecting funding markets. If equity repo financing has been a major driver of recent equity strength, then liquidity demands around settlement dates could explain the market’s recent behavior. I could be wrong, but despite last week’s unexpected outcome, I don’t think it’s time to abandon the thesis.
Anyway, have a great weekend, and we’ll see you again soon. Bye.
Defined Terms and Jargon by ChatGPT
Treasury Settlement Date — The date when buyers must pay for Treasury securities they purchased, often creating temporary liquidity demands in funding markets.
VIX (Volatility Index) — A market measure of implied volatility derived from S&P 500 options; often interpreted as a “fear gauge.”
Implied Correlation — A metric estimating how correlated individual stock volatilities are expected to be in the future based on options pricing.
Dispersion — The degree to which individual stock returns vary from each other; high dispersion means stocks are moving independently, low dispersion means more uniform movement.
General Collateral Rate (GC Rate) — The interest rate for borrowing cash overnight in the repo market using high-quality collateral like Treasuries.
SOFR (Secured Overnight Financing Rate) — A benchmark rate measuring the cost of borrowing cash overnight collateralized by Treasuries.
Standing Repo Facility (SRF) — A permanent Fed facility that provides cash to eligible institutions in exchange for Treasury collateral at a fixed rate.
Reverse Repo Facility (RRP) — A Fed facility where institutions with excess cash lend it to the Fed in exchange for collateral and interest.
TGA (Treasury General Account) — The U.S. Treasury’s cash account at the Fed; changes in its balance affect the banking system’s reserve levels.
Equity Repo Financing — Borrowing cash using equities as collateral; can influence equity demand and leverage.
DTC (Depository Trust Company) — A clearing and settlement entity that records and facilitates securities transactions; changes in its transaction volume can reflect underlying market stress or liquidity dynamics.
Disclaimer
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