No Pain, No Gain

One of our highest conviction theses at the start of the year was that — given a more supportive liquidity backdrop — risk assets would continue to outperform. So far, they’ve done exactly that.

We still believe we’re in the midst of a liquidity cycle uptrend, but today, we want to draw attention to a few potential headwinds to be mindful of as we enter Q2.

The point is not to raise false alarms or proclaim markets are set to dump. It’s intended to provide some color on the evolving macro backdrop and what to look out for if some of these trends continue. Notably, any market weakness could create ripe opportunities for those with similar long-term convictions.

Fed Liquidity Woes

One of the most notable headwinds is a local top in central bank liquidity. In mid-January, we were already seeing signs that the expansion in central bank liquidity was starting to stall. This is in contrast to the trend that’s defined the last 6-8 months, which the Fed and PBOC have led.

Luckily, this coincided with the launch of spot Bitcoin ETFs, driving another wave of excitement and demand for BTC. This boost helped to combat the drag we may have otherwise expected due to waning liquidity support.

But the question remains: Will this trend of fund inflows continue? And will demand remain strong enough to outweigh any near-term disruptions in this current liquidity cycle?

On one hand, the immediate outlook for Fed Liquidity is less favorable than it was 6-8 months ago.

• The Fed is still allowing USTs to roll off its balance sheet.
• However, the UST roll-off has been outpaced by a more rapid drawdown in the RRP over the last 8-9 months, which has helped boost net liquidity (and asset prices).
• But the drawdown of the RRP has slowed considerably in recent times— and appears to be bottoming (at least for now). Without it, we could see volatility increase if risk assets come under pressure.
• This comes at an inopportune time as US tax season ramps up, as we will likely see a liquidity drain from MMFs and reserves.

Any near-term pullback in Fed liquidity increases the risk of a more broad market pullback.

Beware Higher Yields & Stronger Dollar

Meanwhile, the outlook for the US economy has shifted from one of heightened recession risk towards one of economic st