Financial Market Liquidity After Tax Day

The abundance of financial market liquidity has served as a tailwind for markets over the past six months, buoying equity and credit valuations despite sharp swings in Fed expectations. As April's tax deadline moves into the rearview, the picture for liquidity is less clear and could introduce some uncertainty and heightened volatility to financial markets. This comes amid a backdrop of positive market-wide sentiment.??

Liquidity can refer to two concepts, both of which are key to the functioning of financial markets. One definition of liquidity is the quantity of funds available to market participants. If funds are abundant or can be borrowed easily, then there are simply more dollars for a given financial asset or economic activity, which should be positive for both. The other definition of liquidity is the ability of market participants to transact: the buying and selling of assets without an outsized effect on prices. The two definitions of liquidity are interlinked and self-reinforcing, as the quantity of funds available in the financial system is related to the ease with which a market participant can buy and sell a financial asset.?????

The Fed and Treasury are key in determining the amount of liquidity available to markets. The Fed injects or drains monetary liquidity through its balance sheet and interest rate policies, while the Treasury?could affect liquidity by modifying its government debt issuance profile. The chart below shows a common measure of US liquidity as defined by funds available to market participants. Total US liquidity has been increasing, especially since October 2023 and despite the Fed continuing to shrink its balance sheet. This increase in liquidity is attributable to a smaller Treasury bill issuance profile and a decrease in the Treasury General Account (which means the Treasury is spending less than it is issuing in bonds), which on the margin keeps more funds in the private sector.?

We believe this is one of the big factors driving spreads close to cycle lows – lows not seen since 2021.??

Tax receipts will boost the Treasury's coffers, which is a net drain from the private sector to the Treasury. It’ll be instructive to see the level of tax receipts around the April 15th?deadline, which is estimated to be around $500 billion, most of which will be coming from bank reserves.??

While the disruption to interbank funding markets should be minimal in the near-term, we will be focused on the Treasury's refunding announcement on May 1st, when the issuance calendar for both T-bills and coupon bonds is released.?A higher level of T-bill issuance than expected would result in a bigger drain on the Fed's reverse repo facility/private sector bank reserves. If the Treasury elects to instead issue more coupon bonds, then markets must contend with a higher level of duration risk, which could have ripple effects for financial assets across the risk spectrum.??

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