U.S. gov. shutdown to trigger a 'dollar shortage'?

In fact, the recent short-term liquidity crunch of the US dollar was briefly mentioned by Dolphin Research in the Weekly Strategy Report when discussing the impact of the US government shutdown.

However, the continued liquidity tightness has started to affect beneficiaries under abundant liquidity, such as Bitcoin, and tech growth stocks with weak fundamentals and full valuations. It even seems like a tide of US dollars is receding, revealing a batch of small stocks running naked.

So, why is the market suddenly short of US dollars? How long will it last? Should we run away or be a Ninja Turtle? Dolphin Research shares some thoughts:

1) The Treasury becomes a Pixiu that only eats but doesn't spit out

From the Federal Reserve's balance sheet, it is clear that the Treasury had completed the rebuilding of the TGA account by the end of September. If not for the shutdown in October, the plan was to convert the TGA cash raised through financing and bond issuance into fiscal funds for the real economy.

However, after the shutdown began in October, the Treasury continued fiscal financing and bond issuance as planned. Note that the further increase in TGA since October has mainly been at the expense of squeezing bank reserve deposits, rather than the surplus liquidity of the banking system—the reverse repo balance.

After raising these funds, they couldn't be distributed to the real economy due to the government shutdown, lying idle in the Federal Reserve's account, effectively turning the Treasury into a Pixiu that only absorbs liquidity.

The TGA has been rebuilt from a low of less than $300 billion to nearly $1 trillion, absorbing $700 billion from the market. Since October, it has accumulated $160 billion.

2) Federal Reserve's quantitative tightening "adds insult to injury"

Another ongoing reason is that although Powell mentioned in the recent FOMC meeting that quantitative tightening would end on December 1st (specifically stopping the reduction of Treasury holdings while continuing to reduce MBS and investing the matured MBS amount into Treasury bills), the current quantitative tightening is still progressing, exerting additional pressure on liquidity.

3) Indicators of liquidity shortage: widening spread between official and market interest rates

Let's start with some basic concepts. Everyone should be very familiar with the Federal Reserve's target federal funds rate recently adjusted to 3.75%-4%, but this is just a target. Implementing the central bank's will into actual lending is another matter.

Corresponding to the Federal Reserve's target federal funds rate is the Effective Federal Funds Rate (EFFR)—the rate at which depository institutions lend to each other from their reserve accounts, which is the rate indicator managed by the Federal Reserve. This rate is controlled through an upper and lower corridor formed by two rates to ensure the EFFR stays within the Federal Reserve's policy target range. These two limits are:

a. IORB: The interest rate paid by the Federal Reserve on reserves held by banking financial institutions, known as IORB.

b. ON RRP: Non-bank financial institutions also place their money with the Federal Reserve (by purchasing Federal Reserve securities and agreeing to sell them back to the Federal Reserve at a specific time), and the interest paid by the Federal Reserve on these deposits is called ON RRP.

IORB is the deposit rate given by the Federal Reserve to banking financial institutions, forming the upper limit of the EFFR (there is no reason for the interbank lending market to pay a higher rate than this, as they can directly deposit with the Federal Reserve to earn this rate. Therefore, IORB acts as an upward constraint);

ON RRP is the rate given by the Federal Reserve to non-bank financial institutions that cannot obtain IORB, forming the lower limit of the EFFR (if the market rate is lower than the ON RRP rate, the primary fund lenders would prefer to invest their funds with the Federal Reserve to earn the ON RRP interest, preventing the market lending rate from being too low).

The Federal Reserve can basically ensure that the EFFR is controlled between these two rates through IORB and ON RRP. These three rates are essentially the official manifestation of the Federal Reserve's interest rate control targets.

SOFR is the broad overnight repo rate collateralized by US Treasuries, serving as the "risk-free" benchmark in the US dollar market (the official replacement for LIBOR), and is the actual trading rate derived from the US dollar market.

Typically, in a market with abundant funds, SOFR may trade close to ON RRP, while in a severe liquidity shortage, it may significantly exceed IORB.

Recently, the deviation has widened significantly. The Federal Reserve has set the target rate to a maximum of 4%, but the SOFR rate is at 4.22%, indicating that the market rate SOFR is clearly outside the Federal Reserve's desired target range, signaling tight US dollar liquidity.

So, the key to resolving the short-term liquidity dilemma clearly lies with two departments:

1. Treasury: When will the US government shutdown end? Obviously, the one who tied the bell must untie it.

2. Federal Reserve: Shift to "quantitative easing," temporarily releasing liquidity: For example, by purchasing bank Treasuries to release liquidity (repo), structurally releasing liquidity to avoid systemic liquidity risks, effectively blurring the lines between monetary and fiscal policy.

Ultimately, this issue will likely become a tug-of-war between the donkey and elephant parties, a fiscal and monetary battle over who will compromise first.

Let's talk about the Federal Reserve's previous intervention conditions:

The last time the Federal Reserve directly released liquidity through repo operations was in September 2019, when SOFR was at 5.25% and EFFR at 2.3%. Note that the EFFR had already exceeded the upper limit of the then-policy rate target of 2-2.25%, with a spread of nearly 300 basis points.

The possible conditions for the Federal Reserve's intervention seem to be: a) a high spread; b) most importantly, the EFFR exceeding the interest rate corridor range, causing the Federal Reserve's interest rate corridor control method to fail.

In line with these conditions, the EFFR is currently still within the interest rate corridor range, and the current spread has not exceeded 30 basis points, so it seems unlikely that the Federal Reserve will step in to clean up the mess of the donkey and elephant dispute.

If this is the case, to prevent liquidity from further affecting small and mid-cap stocks, virtual assets, and other liquidity-sensitive assets in the secondary market, the core hope should still be on when the US government will restart.

Regarding the US government restart, Dolphin Research notes that the market generally expects it to be in the middle of this month. As more key departments issue salaries and the number of people unable to receive benefits increases, it may force a compromise in the US bipartisan struggle, but Dolphin Research finds it difficult to make a judgment.

However, it is comforting that once the shutdown ends, the trillion-dollar cash pile currently accumulated by the Treasury will instead fuel a liquidity frenzy, allowing liquidity-sensitive small stocks to rally again.

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