DIA, IWM, QQQ, SPY ETFs brace for a major liquidity crisis risk
- American stocks have jumped in 2023 and erased most of last year’s losses.
- Most of these gains are because of big-tech companies like Nvidia and Meta.
- US equities are contending with a significant liquidity risk.
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American stocks have done well in the past few months as the macro environment improves. Invesco QQQ, which tracks the Nasdaq 100 index, has spiked by more than 37% this year, pushing it to the bull market. Similarly, the iShares Russell ETF (IWM), SPDR Dow Jones ETF (DIA), and the SPDR S&P 500 (SPY) have jumped by at least 7% this year.
Why US equities have jumped in 2023
Copy link to sectionAmerican equities and their ETFs have jumped this year for two main reasons. First, big technology companies like Nvidia, Amazon, and Apple have surged. To a large extent, these big tech companies are the primary reason why key indices like the S&P 500 and Nasdaq 100 indices have jumped. Estimates are that the S&P 500 index is negative for the year when you exclude the biggest tech companies.
Second, these stocks have jumped because of the signs that the Fed will start pivoting soon. Economists believe that the Fed will likely start pausing its rate hikes soon. If this is correct, it means that the terminal rate will be lower than what some analysts were expecting.
Third, equities have jumped as the US narrowly avoided a default. Joe Biden signed a bill that was reached last week. An unprecedented default would have led to a major dive in American equities and other assets.
Still, there are a few risks to the market. On Monday, I wrote that Morgan Stanley still believes that US indices could be hit by weaker corporate earnings. The bank expects that EPS and revenue growth will be much slower than expected.
Liquidity risk is real
Copy link to sectionIn addition to earnings growth, I believe that US ETFs like SPY, QQQ, and DIA are contending with an elevated liquidity crisis. For one, while investors are focusing on interest rates, the Fed is also reducing liquidity in the market through quantitative tightening. In all, the bank is reducing liquidity by about $90 billion per month.
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Further, liquidity is falling as depositors move to the short-term bond market, which are offering attractive returns. As a result, data by JP Morgan shows that money supply is expected to decline further in the next few weeks as a flood of Treasuries enters the market. JP Morgan wrote that:
“This is a very big liquidity drain. We rarely see something like that. It’s only in severe crashes like Lehman.”
The icing on the cake is that American regulators are seeking to force banks to increase their capital reserves to prevent more failures. As such, they could suggest raising capital requirements by about 20%, which will also starve liquidity in the market.
Does this mean that US stocks are about to crash? No. But there is a possibility that the liquidity crisis will lead to more volatility among large ETFs like QQQ, DIA, and SPY. Further, in case of a liquidity crunch, these funds are more safer than historically illiquid assets like private equity and private credit.
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