ANALYSIS-Wall Street braces for U.S. tax season liquidity test

Davide Barbuscia reported

NEW YORK (Reuters) - Wall Street is bracing itself for possible stress in the currency markets by putting some cash aside before the U.S. tax period arrives, when high tax-related outflows could hurt market liquidity.

Tax season culminates on April 15, when individuals file their income tax returns with the U.S. federal government, which typically leads to a drop in financial sector liquidity as individuals withdraw cash from bank deposits and money market funds to pay their taxes.

Liquidity, as measured by the Fed's bank reserves and the Fed's Overnight Riparian Repeaters (RRPs), the favored cash depository for money market funds, is still considered ample, but analysts say high capital gains from last year's stock market boom could make this year's outflows particularly significant, which could lead to a surge in short-term interest rates and a rise in interest rates. short-term interest rates.

"It's going to be a potentially bumpy period," said Joseph D'Angelo, director of PGIM's fixed-income money market team." He said, "As a precautionary measure ...... you want to be diligent about your maturity dates and make sure you have enough liquidity before that date.

Some of them say that if borrowing costs rise in response to increased demand for cash, then having more cash before tax day could also allow fund managers to take advantage of any potential volatility.

Spencer Hakimian, chief executive officer of Tolou Capital Management, a macro hedge fund in New York, said he would be prepared to buy short-term fixed-income instruments, such as Treasury bills, if there is a tax-related liquidity event that causes short-term rates to rise.

"We will buy because we think the Fed will intervene in the market," he said.

The Fed did not immediately respond to a request for comment on possible market intervention.

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Any sign of stress will be closely watched by investors and the Fed, as it could give a sense of the financial sector's cash availability after nearly two years of quantitative tightening (QT), which was a reversal of the large bond purchases central banks made to support the market when coronaviruses ravaged the country in 2020.

Jerome Powell, the Fed's chief executive, said last month that the process of reducing the balance sheet could start soon, which may also provide a clue for the Fed to slow down the pace of balance sheet reduction.

In the last round of quantitative easing in 2019, declining bank reserves caused the cost for banks and other market participants to raise overnight loans to fund trades to soar, forcing the Fed to intervene by injecting liquidity into the market through the pump.

"There was a liquidity squeeze and the Fed basically had to completely undo the quantitative easing that they had been doing for years before that event. Now they're trying to avoid that," said John Velis, director of foreign exchange and macro strategy at BNY Mellon Markets." I think they are scarred by the experience," he said.

Villiers said the cash flow from private accounts to the Treasury could be significant because the stock market will be stronger in 2023 than in 2022, and because California was included in the extension last year. He estimated that tax receipts in April of last year were about $380 billion and could reach $600 billion or more this year.

Willis added that this year's tax season could be disruptive because while aggregate liquidity remains ample, the distribution of liquidity among banks could be uneven.

The same concern was emphasized by Mr. Powell last month: "There are times when the total amount of reserves is adequate, even abundant. But that is not the case everywhere, and those places where reserves are not adequate may come under pressure," he said.

Reserve balance

Assessing the adequacy of aggregate reserves can also be tricky.

Speaking at the end of the central bank's rate-setting meeting last month, Powell said the balance sheet contraction should end when the banking sector has enough liquidity to cope with the period of stress, but added that there was no ruling on what that level would be.

Wall Street's largest banks said in a recent survey of Tier 1 traders at the New York Fed that the level of reserves needed to ensure the smooth functioning of the financial system and avoid a repeat of the 2019 liquidity crunch is expected to be around $3.1 trillion. Current reserves are around US$3.5 trillion.

JPMorgan fixed-income strategists, led by Teresa Ho, estimated in a recent report that bank reserve balances could fall to $3.1-$3.3 trillion after the April 15 tax-related outflows as individuals are more likely to withdraw cash from banks than money market funds.

This would leave the reserve balance within the minimum comfortable reserve level indicated by the primary dealers.

"While we don't think this will necessarily lead to a funding crisis,......, it may reveal how long quantitative easing can continue," JPMorgan strategists said.

(Reporting by Davide Barbuscia; Editing by Megan Davies and Nick Zieminski)