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MONEY, CASH, RESERVES, OH MY!

Right now we seem to have broad consensus that a recession will hit sometime toward the end of this year or early next year. The pundits on TV almost unanimously parrot the same talking points: interest rates have risen much too fast, surveys continue to suggest worsening conditions, stocks are down, the Fed tightening lags are about to take hold, etc. etc.

I have been bullish all year and I remain bullish in the face of what I believe will be an intermediate bottom in broad equities, particularly tech, followed by a run at new all-time highs. Usually I justify this on the basis of price action and its various derivatives, but today I’d like to highlight a few charts.

  1. Money stock measures remain well above pre-covid trend. If you recall, as I do, the parabolic move in markets in the months preceding the covid lockdown in March 2020, you’ll notice this coincides quite nicely with the rising delta of M2 at the end of 2019 and early 2020. There has been a reversal since the Fed began their hiking cycle, but downside momentum has slowed. Until downside momentum picks back up and suggests a return to trend within, say, a 6-month period, I will consider this an indication that plenty of money is still out there and thus a substantial tailwind to risk.
  1. Building on the prior chart, money market funds as a percentage of total assets show plenty of dry powder to reinforce risk trends. The period prior to the covid-19 crisis clearly shows an inverse relationship between the Nasdaq 100 and both retail and institutional money market holdings as a percentage of total assets. We see a flight to safety immediately following the onset of lockdowns in March 2020 despite a rally in the tech heavy index, likely due to deflationary economic prints. Eventually both retail and institutional investors (though mostly retail) catch on and exit money market holdings for equities, fueling the Nasdaq 100 higher. Only once the Fed announces its plan to raise the overnight rate do we see a reversal in the Nasdaq 100 and money market inflows as a percentage of total assets, a trend that defined 2022. These money market holdings continue to be high despite 2023 being a record year for the Nasdaq 100. If and when broad recession fears subside, I imagine we will see another wave out of cash equivalents into equities, driving price higher.
  1. The discrepancy between reverse repos (liabilities) and repos (assets) held at the Fed suggests the potential for a massively stimulatory unwinding. We can see the beginnings of this effect at the start of 2023 as bank reserve balances held at the Fed bottomed out and have even begun to rise despite the “commitment” to policy tightening. If the Fed continues to unwind its reverse repo positions, more liquidity will be injected into the system and risk will likely rise. It’s possible this money ends up going toward the purchase of treasuries, but those treasuries would have coupon rate higher than anything we’ve seen since 2007, significantly padding bank bottom lines. If rates fall, even better.

A final note. We have to remember that rising rates only affect individuals and businesses unable to obtain credit. The steepness with which rates rise is not very meaningful if everyone is holding debt financed at near zero interest rates, which is most certainly the case given the policy of easy money during the 2020 covid response.  These refinancings were perfectly timed. The inflationary spiral that took hold in 2021 meant there was a surplus of cash circulating in the economy. Any reasonably minded individual would set aside a safety net for debt repayment rather than seek new credit at much higher rates. As a result, the lags from policy hikes are probably much longer than people realize, and only once everything seems safe and majority consensus turns bullish will we likely see the cracks appear. Markets love maximum pain.

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JANUARY 12, 2025 OBSERVATIONS

Multiple selloffs in equities following strong jobs and ISM data highlights a general concern of returning inflation at a time when valuations are already quite...
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