The False QE Narrative Obscuring Market Liquidity Stress

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Members received this Update on Friday:

The S&P 500 rose by about 20 basis points on Friday, finishing around 6,870. The index has really been struggling over the past week to break out of its current trading range. Although it made a decent attempt on Friday, it still couldn’t push much beyond the 6,850-6,860 range we’ve identified as resistance.

This is mainly because implied volatility has fallen sharply over the past week, leaving the market with very little apparent “juice” at the moment. Even so, realized volatility — at least the nine-day measure — also fell on Friday to 8.63. This continues to suggest that volatility is compressing, and it means that any market move larger than roughly 50 basis points is likely to push realized volatility higher again, which would in turn put upward pressure on implied volatility.

Plus, with the Fed meeting on Wednesday, it seems more likely than not that implied volatility will rise this week, at least heading into the event. If implied volatility does rise heading into the Fed meeting and the index breaks below 6,800, we could see the S&P 500 fall back toward roughly 6,760, which marks a gap created on November 26. Obviously, it doesn’t take me to tell you that if the index continues to move higher instead, it’s likely we push back beyond the all-time highs — despite the liquidity constraints we’ve been seeing in the marketplace and even with Bitcoin’s collapse over the past couple of months.

While we did see overnight funding rates ease somewhat last week — with the general collateral rate slipping to a mid-week low of 3.96% — it moved back up to around 3.98% on December 5, suggesting that SOFR is likely to resume rising. This is important because, despite two Treasury paydowns last week, we haven’t seen general collateral rates decline further. We’ll get two more paydowns this week, but that dynamic will change on the 15th, when roughly $80 billion in Treasury settlements are expected.

Given this setup, it seems likely that we’ve found a floor for repo rates around 3.95%, and as we head into Monday, the 15th, repo rates will probably begin rising again. That suggests that while liquidity pressures have eased, underlying market stress remains unresolved — and is unlikely to resolve unless the Fed allows its balance sheet to move back above $3 trillion. As of now, there’s no indication the Fed intends to expand its balance sheet.

I think one of the biggest misconceptions among social-media market participants is the idea that the Fed is about to restart QE at this week’s meeting. That is not my understanding of what is likely to happen. The Fed is more likely to enter a period of reserve management, which essentially means stabilizing or freezing the asset side of the balance sheet while allowing the liability side to continue to fluctuate.

By my estimate, over the past year, the Fed has averaged roughly $30 billion per month in asset declines, with a range of about $11 billion to $40 billion. This suggests the Fed will begin reinvesting on the order of $30 to $35 billion per month. But all this would do is keep the asset side of the balance sheet neutral and prevent further declines in assets. It would not represent outright QE, which is the expansion of the assets. These would be reinvestments of maturing securities—not net new purchases intended to expand the balance sheet.

The bottom line is this: if you hear people saying the Fed is restarting QE, it reflects a fundamental misunderstanding of what is actually happening and a clear indication that they do not understand how the system works.

-Mike

Glossary by ChatGPT

Basis Points – Units equal to one-hundredth of a percentage point, commonly used to measure changes in interest rates or index levels.

General Collateral Rate – The interest rate paid on high-quality securities used as collateral in repo transactions.

Implied Volatility – The market’s expectation of future price fluctuations derived from options pricing.

Realized Volatility – The actual measured volatility of an asset’s past price movements over a specific period.

Repo Rate – The interest rate at which securities are sold and repurchased in the repurchase agreement market.

Reserve Management – A central bank practice of stabilizing the size or composition of its balance sheet without expanding asset holdings.

SOFR (Secured Overnight Financing Rate) – A benchmark rate representing the cost of overnight borrowing collateralized by Treasury securities.

Trading Range – A price band in which an asset repeatedly trades without breaking meaningfully higher or lower.

Treasury Paydowns – Reductions in outstanding Treasury debt when maturing securities are repaid, temporarily injecting liquidity into the financial system.

Volatility Compression – A reduction in both implied and realized volatility that indicates increasingly narrow price movement.

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