Investment Review №333. Right to hedge

Financial markets have been trending lower since late October, a development for which my readers were well positioned. Following the onset of the government shutdown, I advised considering hedging instruments, and on October 27 I highlighted elevated market valuations and the risks of overly optimistic earnings-season expectations—which began to materialize on October 30. Volatility has since increased, with the Nasdaq 100 technology index falling more than 7%. Risks tied to inflated valuations of AI projects and excessive capital inflows remain evident, driving up the cost of default insurance among technology companies. Yet new concerns have also emerged. On October 31, usage of the Federal Reserve’s Standing Repo Facility (SRF) surged to a record $50.35 billion—the highest level since the tool was introduced in 2021. At the same time, the SOFR rate (a key benchmark for money-market interest rates) jumped 22 basis points to 4.22%, marking the largest single-day increase this year. The spread between SOFR and the Fed’s reserve rate widened to 32 basis points, the highest since March 2020, when the repo market was on the brink of collapse. While end-of-month spikes are not unusual, the magnitude of this move was exceptional. Moreover, volatility persisted even after the month closed: on November 4, SRF usage registered $14.75 billion, the second-highest reading in its history.

These developments stem from the Federal Reserve’s quantitative tightening (QT), with the balance sheet shrinking from a peak of $9 trillion in the summer of 2022 to below $6.6 trillion. Reserves in the banking system have fallen to $2.85 trillion, the lowest level since early 2021, underscoring the system’s growing demand for liquidity. It is for this reason that the Fed has announced the conclusion of quantitative tightening effective December 1.

Is the situation critical for investors who were unprepared for the sell-off? No. Following the end of the government shutdown, the Treasury is expected to release reserves back into the system, helping ease the liquidity drain. It is also important to note that reserve levels remain well above pre-COVID benchmarks ($1.5–1.7 trillion), meaning there are no pronounced systemic problems. Moreover, investors should not abandon the idea of a Holiday Season rally. Assets in money market funds have reached a historic high of more than $7 trillion, equivalent to roughly 13% of the S&P 500’s market capitalization. These funds currently yield 3.8–4.4%, but with inflation around 3% and upcoming Fed rate cuts, real returns will decline. With each rate reduction, capital will gradually flow into riskier assets in search of yield—eventually reaching the equity market.

It is impossible to predict the market’s moves with perfect accuracy, but let’s sketch one plausible scenario. Starting December 1, after the Thanksgiving holiday, bankers, institutional investors, and retail participants will return to the market, observing the completion of several risk repricings related to AI, alongside additional liquidity from the end of QT and the government shutdown. Dress this mix with a gradual flow of funds out of money markets and strong earnings-season results, and you have the recipe for a festive “Christmas dish”—the New Year’s rally. And the volatility? Think of it as the price of admission to this splendid investor’s feast.