The US Federal Reserve (FED) recently began an attempt to shrink its $8.9 trillion balance sheet by halting purchases of billions of dollars worth of Treasury bills and bonds.. The measures were implemented in June 2022 and coincided with the total cryptocurrency market capitalization falling below $1.2 trillion, the lowest level seen since January 2021.
A similar move occurred with the Russell 2000, which hit 1,650 points on June 16, levels not seen since November 2020. Since this drop, the index has gained 16.5%, while the total cryptocurrency market capitalization has not. been able to recover the level of USD 1.2 billion.
This apparent disconnect between the crypto and equity markets has left investors wondering if the growing Federal Reserve balance sheet could lead to a longer-than-expected crypto winter.
The Fed will do whatever it takes to fight inflation
To stem the economic slowdown caused by government-imposed restrictive measures during the Covid-19 pandemic, the Federal Reserve added $4.7 trillion in bonds and mortgage-backed securities from January 2020 to February 2022.
The unexpected result of these efforts was 40-year inflation, and in June, US consumer prices soared 9.1% from 2021.. On July 13, President Joe Biden said June’s inflation data was “unacceptably high.” Additionally, Federal Reserve Chairman Jerome Powell declared on July 27
“It is essential that we bring inflation down to our 2% target if we are to have a sustained period of strong labor market conditions that benefit everyone.”
That is the fundamental reason why the central bank is withdrawing its stimulus activities with unprecedented speed.
Financial Institutions Have a Cash Abundance Problem
A “repurchase agreement,” or repo, is a short-term transaction with a buyback guarantee. Similar to a secured loan, a borrower sells securities for an overnight financing rate under this contractual arrangement.
In a “reverse repo,” market participants lend cash to the US Federal Reserve in exchange for US Treasuries and agency-backed securities.. The lenders are hedge funds, financial institutions and pension funds.
If these money managers are unwilling to allocate capital to lending products or even offer credit to their counterparties, then having that much cash on hand is not inherently good because they must provide returns to depositors.
On July 29, the Federal Reserve’s Overnight Reverse Repo Facility hit $2.3 trillion, approaching its all-time high. Nevertheless, holding so much cash in short-term fixed income assets will cause investors to bleed to death in the long-term, considering today’s high inflation. Something that is possible is that this excess liquidity ends up being transferred to the markets and risk assets.
While record demand for parking cash could signal a lack of confidence in counterparty credit or even a sluggish economy, for risky assets there is a chance of increased inflows.
Definitely, if you think the economy is going to crash, cryptocurrencies and volatile assets are the last places in the world to seek refuge. However, at some point, these investors will not take any more losses by relying on short-term debt instruments that do not hedge inflation.
Think of the Reverse Repo as a “security tax,” a loss someone is willing to incur for as little risk as possible: the Federal Reserve. At some point, investors will regain confidence in the economy, which will have a positive impact on risk assets, or they will stop accepting sub-inflation returns.
In summary, all this cash is waiting on the sidelines for an entry point, whether it be in real estate, bonds, equities, currencies, commodities or cryptocurrencies. Unless runaway inflation magically disappears, some of this $2.3 trillion will end up flowing into other assets.
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