Stocks Face Resistance as Fed Reserves Decline : Analysis

Stocks Face Resistance as Fed Reserves Decline: Analysis 

The movement of funds in the US central bank reserves, or their monthly fluctuations, indicates further potential resistance for stocks in the near term.

Even though the Federal Reserve is gradually reducing its quantitative easing measures, the reserves held by banks are still significantly higher, by nearly $400 billion, compared to when the Fed began reducing its balance sheet in June 2022. Despite the overall decrease in the Fed's balance sheet, this surplus of reserves persists.

The decision by the Treasury to focus on issuing short-term treasury bills has played a significant role in enabling assets with risk to increase in value despite the restrictive monetary policies. This decision allowed money market funds to utilize reserves parked at the Fed's reverse repo facility to finance government operations.

However, for assets with risk, particularly stocks, their short-term performance is influenced not only by the increase in reserves but also by the rate at which these reserves are growing. The graph provided illustrates that the momentum of reserves, measured by the change in their change over a month, mirrors the short-term fluctuations of the S&P index. This momentum has been declining, indicating the challenges stocks are facing.

These challenges are expected to persist. In the immediate future, reserves have decreased due to tax payments. The Treasury's account at the Fed has increased by over $240 billion to $906 billion since the previous week as tax revenues flowed in, leading to a reduction in reserves. The Treasury aims to maintain this account around $750 billion, so as the Treasury spends these funds, reserves will be reintroduced into the system.

Nevertheless, reserves are likely to face increasing pressure as the reverse repo program declines. This program recently reached its lowest levels in nearly two years, dropping to $327 billion. While some of this decline is attributed to tax-related factors, the rising yields on treasury bills, particularly those with six- and twelve-month maturities, are making these bills more attractive for money market funds. Consequently, these funds are withdrawing funds from the reverse repo program to invest in treasury bills.

This shift not only gradually reduces the liquidity support for stocks this year but also elevates funding risks. Given this evolving landscape, investors should exercise greater caution and monitor the situation closely.