High tax expenditures may cause a sharp contraction in market liquidity, and the Federal Reserve has been "spooked" by the ghost of 2019...
Wall Street analysts have indicated that as the April tax deadline approaches, the risk of chaos in the U.S. financing market is also increasing.
Broadly speaking, the payment rush at this time of year typically sucks hundreds of billions of dollars out of the banking system. Due to increased income and a booming stock market, Americans are expected to pay more taxes this year than in previous years, leading to bank reserves potentially falling below the key level that many speculate is crucial for the stability of the financing market.
This may remind some of 2019 when a sudden increase in corporate taxes, coupled with a significant drop in bond issuance, led to a sudden surge in liquidity demand, causing overnight financing markets to fall into chaos, ultimately forcing the Federal Reserve to intervene. Market observers say that while no one is predicting such a scale of turmoil this time, the possibility of turmoil should not be ignored.
JPMorgan's head of short-term interest rate strategy, Teresa Ho, said: "The most concerning thing is how close we are to the lowest 'comfortable' reserve level. We will see liquidity being drawn out of the system during the tax season. This is only slightly different from the situation at the end of the month and quarter, but it still has the potential to have a disruptive impact."
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Bank reserves (cash held by institutions at the Federal Reserve to meet unexpected demands) currently stand at $3.62 trillion, and Wall Street forecasts that potential tax-related outflows could approach at least $400 billion, causing reserves to drop below the so-called "comfortable" level of $3 trillion.
In the meantime, as the tax deadline approaches, the asset size of money market funds has been reduced. Assets held by individuals in government funds (mainly invested in securities such as Treasury bills, repurchase agreements, and institutional debt) decreased by about $10.3 billion, almost double the outflow of funds in the week before the 2022 tax deadline.
Ho said that in the short-term financing market, any tax-related pressure is most likely to first appear in the rise of the Secured Overnight Financing Rate (SOFR), as investors scramble to get cash, leading to a liquidity crunch. SOFR is a key benchmark linked to the daily liquidity needs of the financial system. She said that trading volumes in the federal funds futures market should also be monitored to see if lending activity picks up.
Driven by a series of events such as banks cutting loans for regulatory purposes, SOFR peaked at the end of November and December last year.
Is liquidity risk a cause for concern?Strategists at Societe Generale have indicated that as of March, the Treasury Department's cumulative personal tax revenue was $44 billion higher than the same period last year. The strategists forecast that personal tax revenue for April this year will exceed the $381 billion projected for 2023, but it will not reach the levels seen in 2022.
According to data from the government and the Federal Reserve, two years ago, due to a booming stock market and a robust economic recovery, the Treasury Department's tax revenue reached nearly $600 billion, while banks withdrew $446 billion. These funds were deposited into the Treasury General Account (TGA), which operates similarly to the government's checking account at the Federal Reserve. The TGA is closely monitored by the Federal Reserve, as an increase in the TGA's cash balance leads to a decrease in bank reserves.
In 2022, the impact of the tax season on the financing market was minimal, as the Federal Reserve had not yet begun to reduce its balance sheet (quantitative tightening). Even after tax-related expenditures, banks still had approximately $3.32 trillion deposited with the Federal Reserve and about $1.8 trillion in the Overnight Reverse Repo Facility (RRP), which serves as a barometer for excess liquidity in the financial system.
A survey by the New York Fed of primary dealers shows that while bank reserves are still at a high level, there are concerns that tax-related expenditures this month could bring the total reserves down to the lowest comfortable level of between $3 trillion and $3.1 trillion.
Considering that RRP balances have fallen by three-quarters over the past two years, market observers are vigilant about potential liquidity tightening, and even the Federal Reserve is discussing when to slow the pace of quantitative tightening to avoid a repeat of the surge in overnight financing costs in 2019.
Federal Reserve Chairman Powell stated last month that policymakers plan to soon reduce quantitative tightening. Meanwhile, the minutes of the March 19-20 meeting released on Wednesday show that policymakers favor "as early as possible" easing of quantitative tightening to avoid market pressure. As RRP balances approach zero, any future quantitative tightening could lead to further loss of bank reserves, "and the pace could be rapid."
John Velis, a foreign exchange and macro strategist at BNY Mellon, said: "The Fed is really spooked by the ghost of 2019." He estimates that if tax-related expenditures approach the levels seen in 2022, bank reserves could decrease by about $500 billion. "There is a general concern that if the situation of 2019 reoccurs in some form, they will eventually turn to quantitative easing, which means expanding the balance sheet."
In September 2019, an increase in government borrowing and corporate tax-related expenditures exacerbated the already short bank reserves, and at that time, the key lending rate surged fivefold.
Some market observers also believe that over time, concerns about a resurgence of turmoil seem unfounded.
Stronger tax revenue means that the Treasury Department can issue fewer short-term bonds. U.S. Bank strategists Mark Cabana and Katie Craig said that with reduced supply, excess cash at the front end of the bond market may flow into the Federal Reserve's RRP facility as a liquidity backstop. They expect the financing market to continue to perform well.For Velis at Bank of New York Mellon, he is currently on the sidelines and believes that risks still exist. Velis stated that individuals will be using their bank accounts to pay taxes more than usual because they avoid withdrawing cash from other investment instruments with yields much higher than 5%. Additionally, there is a large group of California taxpayers who applied for a deferral last year due to natural disasters and are now facing a deadline in April.
"If we see repurchase rates soaring in the middle of the month, then you know there's a problem," Velis said, "It's a significant risk that warrants attention."