The US Federal Reserve (FED) recently launched an attempt to shrink its $8.9 trillion balance sheet by halting billions of dollars in Treasuries and bond purchases. The measures were implemented in June 2022 and coincided with the total crypto market cap falling below $1.2 trillion, the lowest level seen since January 2021.
A similar move happened for the Russell 2000, which hit 1,650 points on June 16, levels not seen since November 2020. Since that drop, the index has gained 16.5%, while the total market capitalization of the crypto was unable to recover the $1.2 trillion level. .
This apparent disconnect between crypto and stock markets has investors wondering if the Federal Reserve’s growing balance sheet could lead to a longer-than-expected crypto winter.
The Fed will do whatever it takes to fight inflation
To mitigate the economic slowdown caused by the restrictive measures imposed by the government during the Covid-19 pandemic, the Federal Reserve added $4.7 trillion to bonds and mortgage-backed securities from January 2020 to February 2022.
The unexpected result of these efforts has been 40-year high inflation, and in June US consumer prices jumped 9.1% from 2021. On July 13, President Joe Biden said data from June inflation was “unacceptably high”. Additionally, Federal Reserve Chairman Jerome Powell said on July 27:
“It is essential that we bring inflation down to our 2% target if we are to have an extended period of strong labor market conditions that benefit everyone.”
This is the main reason why the central bank is withdrawing its stimulus activities at unprecedented speed.
Financial institutions have an abundance of liquidity problem
A “repurchase agreement”, or repurchase agreement, is a short-term transaction with a guarantee of repurchase. Similar to a secured loan, a borrower sells securities in exchange for an overnight funding rate under this contractual arrangement.
In a “reverse repurchase agreement,” market participants lend money to the US Federal Reserve in exchange for US Treasury bills and agency-backed securities. The lending side includes hedge funds, financial institutions, and pension funds.
If these fund managers are unwilling to allocate capital to loan products or even offer credit to their counterparties, having so much liquidity is not inherently good because they have to provide returns to depositors.
On July 29, the Federal Reserve’s Overnight Reverse Repo Facility reached $2.3 trillion, approaching its all-time high. However, holding so much cash in short-term fixed-income assets will make long-term investors bleed, given today’s high inflation. One thing that is possible is that this excess liquidity will eventually move into the markets and into risky 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 the possibility of increased inflow.
Of course, if one thinks the economy is going to crash, cryptocurrencies and volatile assets are the last places on earth to seek refuge. However, at some point, these investors will no longer suffer losses by relying on short-term debt securities that do not hedge inflation.
Think of the Reverse Repo as a “safety tax”, a loss someone is willing to take for the lowest possible risk – the Federal Reserve. At some point, investors will either regain confidence in the economy, which has a positive impact on risky assets, or they will no longer accept returns below the level of inflation.
In short, all that cash is waiting on the fringes for an entry point, be it real estate, bonds, stocks, currencies, commodities, or crypto. Unless runaway inflation magically disappears, some of that $2.3 trillion will end up being transferred to other assets.
The views and opinions expressed herein are solely those of the author and do not necessarily reflect the views of Cointelegraph. Every investment and trading move involves risk. You should conduct your own research when making a decision.