The equity market has shown remarkable resilience over the past two weeks despite rising U.S.-China trade tensions, a spike in equity market volatility, and growing credit concerns tied to business development company (BDC) and regional bank lending losses. While these factors have pulled the S&P 500 back from record highs, technical damage at the index level has been rather minimal. The more notable developments have arguably occurred in the money markets.
Last Thursday, for instance, the Federal Reserve’s (Fed) Standing Repo Facility (SRF) was tapped for $8 billion. It was then tapped again for $2 billion on Monday. The SRF is a permanent tool the Fed uses to keep short-term interest rates stable and ensure the smooth functioning of money markets. It operates by offering overnight loans to banks and eligible institutions in exchange for high-quality collateral such as U.S. Treasuries, with the collateral repurchased the following day at a modest interest cost. The SRF is really meant to serve as a safety valve of sorts — if banks can’t easily borrow cash in the market, they can always turn to the Fed at a set interest rate. Through this mechanism, the Fed can prevent sudden spikes in borrowing costs and help alleviate short-term run-of-the-mill funding pressures.
While the SRF is offered daily, usage outside of typical quarter-end liquidity crunches is unusual and may signal that system-wide liquidity is beginning to tighten more meaningfully. This matters for equities because abundant liquidity is inherently supportive of risk assets. Conversely, when liquidity conditions become tighter, investors tend to become more selective, creating a potential headwind for risk assets such as equities.
All that said, sporadic draws on the SRF do not constitute a trend. However, if usage of the SRF becomes more persistent, it could be a clear indication that liquidity is starting to meaningfully tighten and present a dynamic that equity markets would likely find difficult to ignore. In short, these early signs of tightening liquidity warrant close monitoring as signs of more persistent stress in the funding markets could easily shift the risk backdrop for equities.
LPL Research’s Strategic and Tactical Asset Allocation Committee (STAAC) remains neutral on global equities, with benchmark allocation recommendations across domestic, developed international, and emerging markets. Within the U.S., we prefer large caps over small caps, and growth over value.
Kristian Kerr drives the broad, house investment strategy for LPL Financial Research. His career includes over 25 years of industry experience.
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