Where's the Hole?
by Steve Northwood, Friday April 15 2005
The Fed has been adding liquidity over the last few sessions and the Treasury has been paying down debt, both of which usually add liquidity and boost the market. Where is all the money going?
This week the Fed has added $11.25 billion in short term liquidity through repurchases and the Treasury has paid down over $26 billion in short term debt with another $7 billion to be paid down on Monday. That is a massive injection of cash that normally would have caused a massive rally. Instead we have seen waves of selling. Where is the money going, or is the liquidity indicator broken?
Let’s take a look beneath the numbers. While Treasury has been paying down debt, they have been pulling back shorter term lending by letting $7 billion in TIOs expire, reducing the net paydown. But the real culprit is taxes.
Every year as the tax deadline approaches, individual entrepreneurs and investors owe taxes on larger-than-expected profits or capital gains. The tax payments on these gains lag by as much as 2 years (or longer) from the time when the gains actually accrue. For example, 2003 was a good year for investors, but much of those capital gains were not realized until 2004, and the taxes on those gains are now due. Those investors have held off paying till the last moment, instead choosing to continue to invest the money until they absolutely have to pay. How much money is involved? Over $100 billion!
If this happens every year, why has this year been so hard on the markets? From late March to early April, 401(k) inflows boost the market. Then beginning around the 8th – 10th of April, the market sells off. My guess is that the effect this year has been magnified because those extra few months of investing (January through March) have not been friendly to investors. The value of those investments earmarked for payments has been shrinking since the first of the year. Investors may have delayed cashing in the funds hoping for a bounce to sell into. Those bounces have been few and far between. Now they are stuck and must sell to pay the tax man, regardless of the bid/ask. That’s what I suspect happened yesterday afternoon.
Will this end after today? Maybe. Why? Although the securities needed to generate the cash have been sold (or will have been after today), the money is still floating in the system. The Treasury hasn’t cashed the checks. In fact, of the $100+ billion Treasury windfall expected this tax season, $90 billion still hasn’t made its way to the IRS. About $55 billion will arrive next week and another $35 billion the week after. The Treasury will continue to pay down debt over those two weeks, but that will only cushion the blow. As we approach the Fed Open Market Committee's policy meeting on May 3rd, the Fed will likely pull back some of the reserves they have recently added.
A rising tide lifts all boats, but a receding tide uncovers the rocks and debris that was hiding just under the surface. The receding tide has exposed the market's submerged debris.
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