The United States is heading towards a "liquidity crisis," and a "government shutdown" is equivalent to an interest rate hike? The next steps are crucial for the market

The United States is facing an increasingly severe liquidity crisis. Despite the Federal Reserve announcing the end of quantitative tightening (QT), the pressure on the funding side has not eased but has continued to worsen. Behind this, the government shutdown is draining market liquidity, with effects comparable to multiple interest rate hikes, but it also lays the groundwork for a rebound in risk assets by the end of the year.

Key financing indicators show that market pressure has reached a critical point. On Monday, the usage of the Federal Reserve's Standing Repo Facility (SRF) reached $14.75 billion, the second highest since the tool was established, following a record high of $50.35 billion last Friday.

More concerning is that the Secured Overnight Financing Rate (SOFR) surged 22 basis points to 4.22% on October 31, far exceeding the Federal Reserve's 3.9% interest rate on excess reserves, widening the spread to 32 basis points, the highest since March 2020.

This indicates that despite the Federal Reserve's interest rate cut last week, the actual financing costs in the market have not decreased. The core reason for the liquidity tightness is that the government shutdown has forced the Treasury to increase its cash balance from $300 billion to $1 trillion over the past three months, draining market liquidity. The Federal Reserve's reserves have fallen to $2.85 trillion, the lowest since early 2021, while foreign commercial banks' cash assets have plummeted by over $300 billion in four months.

However, there are also opportunities amid the crisis. Goldman Sachs and Citigroup expect the government shutdown to end within two weeks. Once the government reopens, the Treasury will release hundreds of billions of dollars in cash into the market, and this "invisible quantitative easing" could trigger a massive buying spree in risk assets, driving the stock market significantly higher by year-end.

Liquidity Indicators in Critical Condition

Several core indicators in the money market show that liquidity in the U.S. financial system has dropped to dangerous levels. Although the market generally expects that funding conditions will stabilize after the end of the month—banks typically "window dress" their balance sheets and absorb liquidity at month-end—this normalization has not occurred.

Last Friday, the spread of the general collateral repo rate in the tri-party repo market (relative to the excess reserves rate) surged to 25 basis points, also reaching the highest level since the pandemic. According to ICAP data, on Monday, the overnight general collateral repo rate fluctuated sharply between 4.14% and 4.24%, far exceeding the Federal Reserve's 3.9% excess reserves rate and also surpassing the 3.75% to 4.00% federal funds target range. The MBS repo rate was as high as 4.28% to 4.31%

The market originally expected that after the end of the month, the year-end settlement in Canada, and the completion of government bond auction deliveries, financing costs would return to normal. However, data from early Monday showed that even with these seasonal factors fading, interest rates remained at abnormally high levels, indicating that liquidity tightness is not solely driven by technical factors.

The Federal Reserve's reserves have fallen to $2.85 trillion, the lowest since early 2021. More critically, the total of reserves and reverse repurchase balances has dropped to its lowest level since the end of 2020.

The balance of reverse repurchase tools, which served as an excess liquidity "reservoir" over the past three years, has fallen to $51 billion, meaning that future repurchase demands can only be met through the standing repurchase facility, further exacerbating funding tightness.

Government Shutdown Drains Liquidity, Equivalent to Implicit Rate Hikes

The ongoing government shutdown is becoming a major driver of liquidity exhaustion in the money market, with the U.S. Treasury General Account (TGA) balance swelling dramatically.

As of last Friday, the TGA balance has surpassed $1 trillion for the first time, reaching a nearly five-year high since April 2021. This means that over the past three months, the Treasury has siphoned off more than $700 billion in cash from the market—soaring from about $300 billion in July to the current level.

This large-scale "cash absorption" by the Treasury has directly led to the exhaustion of market liquidity. According to the Federal Reserve's H.8 report data, cash assets held by foreign commercial banks have become the biggest victims, plummeting over $300 billion from a peak of more than $1.5 trillion in July to $1.173 trillion. In fact, these funds have been requisitioned by the Treasury to maintain daily expenditures during the government shutdown.

This situation has produced an unexpected consequence: the Treasury has effectively become the actual decision-maker of monetary policy, with its fiscal policy determining monetary conditions. It can be said that if the Treasury's cash balance had not soared from $300 billion to $1 trillion within three months, the Federal Reserve might not have announced the end of quantitative tightening.

Analysts believe that the effect of the government shutdown is equivalent to multiple rounds of interest rate hikes, as it has withdrawn $700 billion in liquidity from the market, with a tightening effect comparable to significant monetary policy tightening. The Federal Reserve is still executing quantitative tightening in November, further exacerbating an already fragile funding situation, making the decision to delay the end of quantitative tightening until December potentially another policy misstep.

Bank of America liquidity experts Mark Cabana and Katie Craig have called for the Federal Reserve to consider replenishing bank reserves through the purchase of government bonds or initiating a $500 billion term open market operation. The deterioration of funding conditions presents a dangerous self-reinforcing characteristic; if key indicators continue to worsen, it could trigger a feedback loop similar to the repo crisis in September 2019 or the basis trade collapse in March 2020

Reopening or Triggering a Significant Rebound in Risk Assets

Despite the bleak short-term outlook, the root of the crisis is precisely the key to a potential turning point in the market. Since the government shutdown is the main driver of liquidity tightening, once the shutdown ends, the Treasury will begin to deplete its massive TGA cash balance, releasing hundreds of billions of dollars in liquidity into the economy.

This liquidity release could trigger a massive buying spree for risk assets. A similar scenario played out in early 2021 when the accelerated depletion of the Treasury's cash balance amounted to "invisible quantitative easing," driving a significant rise in the stock market. This script may repeat itself in 2025 to 2026.

Once the government restarts, the release of pent-up liquidity coinciding with year-end could drive a sharp rise in liquidity-sensitive assets such as Bitcoin and small-cap stocks, as well as nearly all non-AI assets. The worse the recent situation, the more reserve liquidity will be released in the medium term.

Bank of America liquidity experts Mark Cabana and Katie Craig have called for the Federal Reserve to consider replenishing bank reserves by purchasing government bonds or initiating a $500 billion term open market operation. The deterioration of funding conditions presents a dangerous self-reinforcing characteristic; if key indicators continue to worsen, it could trigger a feedback loop similar to the September 2019 repo crisis or the March 2020 basis trade collapse.

However, this is not a long-term solution. The massive budget deficit in the U.S. means that financing conditions will deteriorate again, at which point the Federal Reserve will have to intervene, as predicted by Bank of America's Mark Cabana, potentially requiring actual asset purchase operations. But for now, the fate of risk assets rests on the timeline for the government reopening.

Likely to End Shutdown in the Next Two Weeks?

Goldman Sachs expects the government shutdown to most likely end around the second week of November. Key pressure points include the salaries of air traffic controllers and airport security personnel due on October 28 and November 10—similar interruptions in 2019 ultimately contributed to the end of that shutdown.

Goldman Sachs outlined several paths to reopening: a few Democratic senators may change their stance and vote to extend funding under the existing resolution until November 21; a more likely scenario is a compromise where Democrats agree to pass the resolution in exchange for Republican commitments to vote on extending healthcare subsidies after the government reopens; the third, less likely option is for Republicans to eliminate lengthy debate rules to pass the resolution by simple majority.

Prediction markets indicate that the probability of the government reopening before mid-November is about 50%, with the likelihood of dragging past Thanksgiving being less than 20%. Citigroup stated it is "increasingly confident" that the government shutdown will end in the next two weeks. Once the government reopens, data releases will quickly resume, and the Federal Reserve "may receive up to three employment reports" before the December meeting, providing a basis for continuing interest rate cuts