Under multiple liquidity challenges, could there be another round of adjustments in the US stock market in Q2?
In the post-pandemic era, the liquidity environment in the United States is relatively loose. Although the Federal Reserve has raised interest rates by 525 basis points since March 2022, the impact on businesses and households has been limited. The ratio of mortgage repayment expenditures to disposable income for residents is below the 2019 level, and the corporate financing environment remains loose, with credit bond spreads at historical lows. Despite the significant tightening of the interest rate cycle, the liquidity premium has not risen significantly, and the market holds a cautious attitude towards potential future adjustments
A main line of global asset allocation in the post-pandemic era is the "American exceptionalism." The prominent feature of "American exceptionalism" on a fundamental level is that this round of interest rate hikes has not led to a significant tightening of financial conditions, which in turn has not caused operational difficulties for enterprises or signs of economic recession. However, recently, "American exceptionalism" has begun to show signs of loosening.
This inevitably leads the market to reflect: Is the tightening of financial conditions brought about by interest rate hikes merely "a false alarm" or "not the right time"?
In this tightening cycle, the liquidity environment across various sectors in the United States remains relatively loose. The current tightening cycle by the Federal Reserve is the most aggressive since the 1970s, with a cumulative interest rate hike of 525 basis points from March 2022 to July 2023, and it is expected to maintain until September 2024 before shifting to rate cuts. However, this round of interest rate hikes seems to have had no significant impact on the public sector, household sector, or corporate sector.
In the household sector, the ratio of mortgage payments to disposable income is currently 11.3%, lower than the 11.7% level at the end of 2019; consumption has remained strong from 2022 to 2024.
In the corporate sector, the OAS spread of credit bonds has been continuously declining since the second half of 2022 and is currently at a historical low, with the credit environment still within historically loose ranges, making corporate financing very easy; profit growth has accelerated compared to pre-pandemic levels; and debt repayment indicators have improved.
In terms of liquidity, the liquidity premium in the United States has not reached extremely high levels, and the liquidity environment remains loose. There was only one incident of risk involving Silicon Valley Bank (SVB) in March 2023, but the FDIC intervened quickly to resolve it.
The main reason behind this is that a large number of credit bonds from the easing cycle have not yet begun to mature.
The transmission of tightening from interest rate hikes has a time lag. Various sectors of the U.S. economy financed a large amount at extremely low costs in 2020, with corporate bond issuance surging in Q2 2020, and commercial banks also issued a large number of commercial loans in the low-interest-rate environment of 2020. According to Bloomberg data, the total issuance of corporate bonds in the U.S. in 2022 was $3.0 trillion; in Q2 2020 alone, $1.1 trillion was issued.
91% of the corporate bonds issued in 2020 were fixed-rate bonds, locking in extremely low costs. In the high-interest-rate environment following the rate hikes, companies, having sufficient funds and good profits, have significantly reduced their financing activities.
The current problem is: corporate bonds issued in 2020 will expire in large numbers in 2025, and companies face a dilemma: either issue new bonds to repay old debts, which means tolerating the current high financing costs; or use cash to repay debts, which would require cutting capital expenditures.
In the second quarter, a relatively weak liquidity environment after balance sheet reduction will coincide with a peak in debt repayment.
In the second quarter, corporate bond maturities will reach a historical peak. According to Bloomberg data, if early repayment is not considered, corporate bonds due in the second quarter of 2025 will exceed USD 600 billion (Figure 4), corresponding to the unprecedented issuance peak of corporate bonds in 2020, which is 70% higher than the average of the last two quarters of 2024.
More than half of the corporate bonds maturing in the second quarter were issued in Q2 2020 and Q2 2015. We estimate that the average financing cost of these bonds at issuance was 3.6%, and if refinancing occurs, even without an increase in credit spreads, extending at the current financing cost (approximately 5.5%) would increase financial costs by 190bps.
The liquidity environment after balance sheet reduction can hardly be described as loose. The Federal Reserve's overnight reverse repurchase agreements (ONRRP), which serve as a liquidity "buffer pool," have significantly decreased compared to the previous two years; along with the Fed's ongoing balance sheet reduction (QT), the excess reserves in the banking system have also noticeably decreased, which cannot be described as tight, but is also hard to call loose.
![](https://mmbiz-qpic.wscn.net/mmbiz_png/zWatvMNHicndlZqmticodrmFFsicanh6sB17BFiak9p62exiblI0FdrjlgKUvssEicVCCFiasQGoYJSNicP0FGycFh2aUw/640? The current liquidity environment is relatively fragile, and if it encounters a peak in debt repayment, it may lead to a rapid rise in credit spreads. Looking back at the last three rate hike cycles, the peak of corporate bond OAS spreads lagged the last rate hike by an average of 24 months. This round of "epic" rate hikes ended in July 2023, and based on historical experience, the probability of a surge in credit premiums within this year is not low. Therefore, the increase in financing costs mentioned above will far exceed 200bps.
The delay in ending the debt ceiling and balance sheet reduction may "add fuel to the fire."
If a new "debt ceiling" bill is approved mid-year, it may trigger a temporary tightening of liquidity. On January 2, the U.S. Treasury Department activated "extraordinary measures" to maintain government operations, and by February 14, 70% of these "extraordinary measures" had been exhausted, with the expected deadline "X-DATE" likely around June this year.
Historically, the White House usually signs a new debt ceiling bill at the last moment. Although the probability of a government default is low, there may be a significant increase in fiscal bond issuance after the "X-date," leading to tighter market liquidity.
Currently, the market has differing expectations regarding the Federal Reserve's end to QT: The January FOMC meeting minutes show that some Fed officials believe it is appropriate to pause or slow QT before resolving the "debt ceiling" issue; however, the Fed's survey indicates that major Wall Street banks and fund managers expect QT to stop in June or July. If QT ends too late, it may further pressure liquidity.
In summary, the risk of a tightening liquidity environment in the U.S. in the second quarter cannot be ignored, and U.S. stocks may face another round of adjustments. Looking back at the recent liquidity crisis in the U.S.—the Silicon Valley Bank (SVB) collapse, from March 7 to 13, 2023, global stock markets adjusted, the U.S. dollar index fell, and the prices of safe-haven assets like U.S. Treasuries and gold rose, especially the short-end 2Y U.S. Treasury yield, which fell from 5.05% to 4.03% within a week, while SVB and other regional bank bonds were sold off Currently, China's technology and Europe's finance are siphoning funds from the U.S. stock market. Additionally, Japan's wage growth has reached a new high, increasing the likelihood of another interest rate hike by the Bank of Japan this year. The liquidity shock brought about by last year's reversal of Carry Trading is still fresh in memory. With less liquidity support and the ONRRP "safety net," the debt ceiling coinciding with a peak in corporate debt maturities may test U.S. liquidity, fundamentals, and even U.S. stocks again in the second quarter.
Authors: Lin Yan, Pei Mingnan, Source: Chuan Yue Global Macro, Original Title: "Liquidity Challenges in the U.S. in the Second Quarter (Minsheng Macro Lin Yan)"
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