Liquidity, the Fed, and the Treasury: Why Markets Stay Supported

In this blog, we explain how the Treasury’s actions have allowed the Federal Reserve to keep the federal funds rate above 5% and reduce its balance sheet without stalling the economy.

It is a bit academic, so we recommend you read this piece with a cup of coffee instead of a glass of wine.

TLDR: Liquidity in Simple Terms

We love economics, but we realize you may not, so here is an analogy.

Imagine the U.S. financial system is a large tank of water holding various boats. The boats represent financial assets — stocks, bitcoin, and other risk assets.

• When the Federal Reserve shrinks its balance sheet, it removes water from the tank
• Less water means boats sit lower → asset prices typically fall
• When liquidity increases, boats rise → asset prices go up

Recently, the Treasury has added more “water” than the Fed has removed. As a result, stocks and bitcoin have remained supported — even during quantitative tightening.

In the sections below, we explain how this works in more detail.

Background: The Fed’s Mandate and Toolkit

The U.S. Federal Reserve has two primary mandates:

• Maximum employment
• Price stability

The economy naturally cycles. Strong growth pushes employment and prices higher; weaker growth pulls them lower. When these shifts become extreme, the Fed intervenes using monetary tools.

The main tool is short-term interest rates.

The Great Recession and the Birth of QE

During the 2008–2009 financial crisis, interest rates were cut to zero to stimulate the economy. When that was not enough, the Fed introduced a new tool:

Quantitative Easing (QE)

The Fed:

• Purchased Treasury and mortgage-backed securities
• Injected cash and bank reserves into the financial system

This expanded the Fed’s balance sheet from roughly $1 trillion to $5 trillion.

The result:

• Avoided deflation
• Prevented a deeper depression
• Stabilized financial markets

The Pandemic Era Expansion

During COVID-19, QE was used again at an even larger scale.

• Fed balance sheet expanded to roughly $9 trillion
• Combined with fiscal stimulus (direct government payments)
• Created an environment of “too much money chasing too few goods”

Supply chain disruptions worsened the imbalance, leading to:

High inflation across the economy

Today: Tightening Policy Begins

To combat inflation, the Fed took two major actions starting in 2022:

• Raised interest rates from ~0% to ~5.5% at the fastest pace in history
• Began reducing its balance sheet (Quantitative Tightening, or QT)

Why reduce the balance sheet?

The Fed is:

• Removing liquidity from the financial system
• Preparing capacity for future crises
• Reducing balance sheet risk as interest costs rise

These actions were designed to slow growth and reduce inflation — and they have worked partially.

• Inflation has declined
• Growth has slowed from 2021 highs
• But inflation remains above the Fed’s 2% target
• Economic growth has remained stronger than expected

The Key Question: Why Has the Economy Stayed Resilient?

The short answer:

The Fed removed liquidity, but the Treasury replaced it.

How the Fed Removes Liquidity (QT)

As part of QT:

• The Fed allows bonds to mature
• It does not reinvest the proceeds
• This process is called “roll-off”

Result:

• Bank reserves decline
• Money supply contracts
• Financial conditions tighten

Normally, this would significantly slow the economy.

The Treasury’s Counterbalance

At the same time, the U.S. is running a large fiscal deficit that must be financed.

Treasury Secretary Janet Yellen adjusted issuance strategy by:

• Issuing more short-term Treasury bills
• Issuing fewer long-term bonds

This had two effects:

• Supported demand for longer-term Treasuries
• Helped keep long-term yields lower
• Supported risk asset prices

The Reverse Repo Facility: The Hidden Liquidity Engine

A key mechanism in this process is the Fed’s Reverse Repo Facility (RRP).

This facility allows:

• Money market funds and banks to park excess cash at the Fed
• In exchange, they receive short-term Treasuries and interest

At its peak in 2023:

• RRP balances reached ~$1.4 trillion

How Treasury Issuance Changed the System

Yellen effectively used Treasury bill issuance to:

• Pull money market funds out of the RRP facility
• Redirect that cash into Treasury bills instead

This resulted in:

• Declining RRP balances
• Increased Treasury funding of government deficits
• More liquidity circulating in markets

As one analyst summarized:

“By issuing more bills, the Treasury enabled money market funds to fund most of the deficit using otherwise inert liquidity parked at the reverse repo facility.”

Why This Matters

Nothing lasts forever.

Since October 2023:

• Reverse repo balances have fallen from ~$1.4 trillion to ~$400 billion
• They may approach zero in the coming months

Once this liquidity buffer is gone:

• Treasury issuance will more directly drain financial system reserves
• Liquidity conditions may tighten materially

Potential Market Implications

If liquidity is the main driver of asset prices, then:

• Stocks could become more volatile
• Bitcoin and other risk assets may weaken
• Regional banks may face funding pressure
• The Fed may need to slow or halt quantitative tightening

In fact, the Fed has already responded by:

• Reducing balance sheet runoff from ~$60B/month to ~$25B/month

Future Treasury Issuance Risks

Looking ahead:

• Treasury issuance may shift toward longer maturities
• Higher yields could crowd out private sector borrowing
• Financial conditions could tighten further

Politics and Market Stability

There is also a political dimension.

It appears both:

• The Federal Reserve (Jerome Powell)
• The Treasury (Janet Yellen)

prefer relatively stable financial markets, especially during election cycles.

However:

After the election, liquidity conditions and policy direction may become more uncertain.

Key Takeaway

Markets today are being shaped less by earnings alone and more by:

• Federal Reserve balance sheet reduction
• Treasury issuance strategy
• Reverse repo liquidity dynamics
• Fiscal deficit financing needs

Together, these forces determine how much “water” is in the financial system — and therefore how high the “boats” can float.