For much of 2022, the cryptocurrency market was focused on shares of the United States Federal Reserve. The US central bank created a bearish environment for risky assets like stocks and cryptocurrencies by raising lending rates.
Towards the end of 2022, positive economic data, healthy employment numbers and a declining inflation rate raised hopes of the long-awaited slowdown in the pace of interest rate rises. Currently, the market expects rate hikes to be reduced from 50 basis points (bp) to 25 bp before the full end of the rate hike regime in mid-2023.
From the perspective of the Fed’s goal of tightening liquidity and putting an overheated economy and stock market on the ropes, things are starting to look up. It appears that the Fed’s plan for a soft landing through quantitative tightening to curb inflation without throwing the economy into a deep recession may be working. The recent rally in the stock market and Bitcoin can be attributed to the market’s confidence in the above narrative.
Yet another key US agency, the Treasury Department, poses significant risks to the global economy. While the Federal Reserve has been draining liquidity from the markets, the Treasury provided a countermeasure by draining its cash balance and negating some of the Federal Reserve’s efforts. This situation may be coming to an end.
It invokes risks of restricting liquidity conditions with the possibility of a counterproductive economic shock. For this reason, analysts warn that in the second half of 2023 there may be excess volatility.
Behind-the-Scenes Liquidity Injections Undo Fed Quantitative Tightening
The Fed began its quantitative tightening in April 2022 by raising interest rates on its borrowings. The objective was to reduce inflation by restricting market liquidity. Its balance sheet shrank by $476 billion during this period, which is a positive sign considering that inflation fell and employment levels remained healthy.
However, during the same period, the US Treasury used its General Treasury Account (CGT) to inject liquidity into the market. Normally, the Treasury would sell bonds to raise additional cash with which to meet its obligations. However, as the nation’s debt was near its peak, the federal department used its cash to finance the deficit.
Effectively, it is a liquidity injection behind the scenes. The TGA is a net liability on the Fed’s balance sheet. The Treasury had withdrawn $542 million from its TGA account since April 2022, when the Fed began raising rates. The independent analyst of macro markets, Lynn Aldentold Cointelegraph:
“The US Treasury is reducing its cash balance to avoid going over the debt limit, which is adding liquidity to the system. So the Treasury has been offsetting some of the quantitative tightening that the Federal Reserve is doing. A Once the debt limit issue is resolved, the Treasury will refill its account with cash, which draws liquidity out of the system.”
Debt limit and possible economic consequences
US Treasury debt stood at approximately $31.45 trillion as of January 23, 2023. The figure represents the cumulative US government total outstanding over the nation’s history. It is crucial because it has reached the limit of the debt of the Treasury.
The debt limit is an arbitrary number set by the US government that limits the amount of Treasury bonds sold to the Federal Reserve. It means that the government can no longer borrow more.
Currently, the United States has to pay interest on its national debt of USD 31.4 trillion and spend on the welfare and development of the country. These expenses include the salaries of public doctors, educational institutions and payments to pensioners.
Needless to say, the US government spends more than it takes in. Therefore, if you can’t increase the debt, there will have to be a cut in interest payments or in your expenses. The first scenario assumes a default on the US public debt that opens a great Pandora’s box, starting with the loss of confidence in the largest economy in the world. The second scenario poses uncertain but real risks, since non-payment of public goods may induce political instability in the country.
But the limit is not set in stone: Congress votes on the debt limit and has changed it numerous times. The US Treasury Department notes that “since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit: 49 times under Republican presidents and 29 times under Democratic presidents.”
If history is silent, it is very likely that lawmakers will solve these issues by raising the debt limit before any real damage is done. However, in that case, the Treasury would be inclined to increase its TGA balance again; the department’s goal is $700 billion by the end of 2023.
Either by completely draining its liquidity by June or with the help of a debt limit amendment, the behind-the-scenes injections of liquidity into the economy would come to an end. This threatens to create a sticky situation for risky assets.
Bitcoin’s correlation with US stock indices, especially the Nasdaq 100, remains near all-time highs. Alden noted that the FTX crash suppressed the cryptocurrency market in the fourth quarter of 2022, when the stock market rallied on expectations of a lower rate hike. And while Congress delays its decision on the debt limit, favorable conditions for liquidity have allowed the price of Bitcoin to rise.
However, the correlation with the stock markets remains strong, and movements in the S&P 500 and Nasdaq 100 are likely to continue to influence the price of Bitcoin. Nik Bhatia, a financial researcher, wrote about the importance of the direction of the stock market for Bitcoin. He said:
“…in the short term, market prices can be very wrong. But in the longer term, we must take trends and changes seriously.”
With risks stemming from the Fed’s ongoing quantitative tightening and the discontinuation of Treasury liquidity injections, markets are expected to remain vulnerable through the second half of 2023.
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