Base Liquidity
How the foundation of global markets determines the behavior of all assets — and why it underpins any risk cycle...
In its simplest form, base liquidity is the amount of available money in the system, generated by central banks and government financial flows. In the modern global economy, this process is almost entirely centered around the US dollar, making USD liquidity a key factor for all markets, regardless of geography.
Base liquidity is not just another factor among many. It is the foundational layer of the financial system upon which everything else is built: asset prices, access to credit, investor behavior, and the very nature of the market. If yen carry trade can be seen as a mechanism for liquidity transmission, then base liquidity is the source of that liquidity.
This system includes several interconnected elements, each performing a separate function, but together they determine whether there is a surplus or deficit of liquidity in the system.
Central Bank Balance Sheet as the Primary Source of Liquidity
The primary source of liquidity remains the Federal Reserve's balance sheet. It is through this that money is created or withdrawn from the financial system.
When the Fed conducts quantitative easing, it purchases government bonds and other assets, creating reserves in the banking system. This means that banks receive additional liquidity, which they can use for lending or investing. In such an environment, demand for risky assets increases, volatility decreases, and a stable risk-on regime is formed.
During quantitative tightening (QT), the opposite process occurs. The Fed's balance sheet shrinks, reserves decrease, and the system loses liquidity. This leads to tighter financial conditions, limits the use of leverage, and puts pressure on risky assets.
However, it is important to understand that the central bank's balance sheet is only the beginning of the process, not its full reflection.
Bank Reserves as a Channel for Transmitting Liquidity to the Market
The created liquidity enters the real financial system through bank reserves. These determine how capable banks are of sustaining credit activity and participating in financial markets.
When reserve levels are high, banks have more capacity for financing, which promotes credit expansion and supports liquidity throughout the system. This creates an environment where investors can use more leverage and take on more risk.
When reserves shrink, banks' capabilities are limited. This does not always lead to an immediate market downturn but gradually reduces the system's ability to support risk and increases its vulnerability to stress.
Reverse Repo as a Hidden Liquidity Buffer
The Reverse Repo Facility acts as a buffer that temporarily absorbs excess liquidity. During periods when there is an abundance of money in the system, market participants place it in RRP, earning minimal returns but effectively removing these funds from active circulation.
This means that a high level of RRP does not necessarily indicate a lack of liquidity. On the contrary, it is often a signal that there is ample liquidity in the system, but it is temporarily unused.
When the volume in RRP begins to decline, these funds return to the markets. This creates additional demand for assets and can reinforce growth even during periods when the Fed's balance sheet is contracting. This is why the dynamics of RRP often explain discrepancies between formally tight policy and actual market growth.
Treasury General Account as a Factor for Liquidity Withdrawal and Return
The Treasury General Account is another critically important element. It is the account of the U.S. government at the Fed, through which all government financial flows pass.
When the government accumulates funds in this account, liquidity is effectively withdrawn from the banking system, as these funds are not used in the market. This creates a tightening effect even without a change in monetary policy.
When the government begins to spend these funds, liquidity returns to the economy and financial markets. This can create a stimulating effect even during periods of formal policy tightening.
Thus, the TGA is one of the key factors that explains why the market sometimes behaves contrary to expectations.
All these elements together form what can be called the net liquidity of the system. It determines whether the market is capable of sustaining risk or is forced to reduce it.
When liquidity increases, investors have more financing opportunities, leverage expands, and assets receive support. In such periods, equities rise, credit expands, volatility decreases, and risk is perceived as cheaper.
When liquidity contracts, the situation changes. Leverage shrinks, financial conditions become tighter, spreads widen, and risk assets begin to lose support. Even fundamentally strong assets can fall due to limited access to financing.
It is also important to understand that the impact of base liquidity is not instantaneous. It is a slow but fundamental process that determines medium-term trends. This is why the market can continue to grow even amidst negative macroeconomic news — if liquidity remains sufficient.
This establishes a key principle: asset prices are often not a function of news but a function of liquidity. News can be a trigger, but liquidity determines whether the market can absorb it.
The practical conclusion is that any market analysis without considering base liquidity is structurally incomplete. It is not an indicator that provides precise entry or exit points, but it is the foundation that determines in which direction opportunities should generally be sought.
In a phase of liquidity expansion, the market forgives mistakes, supports risk, and allows even imperfect strategies to work. In a phase of liquidity contraction, the situation changes: even good ideas may not materialize due to changes in financing conditions.
Thus, base liquidity is not just background for the market, but its foundation. It determines whether an environment for growth exists, or whether the system is transitioning into a risk-averse mode. In this sense, it stands above any individual strategies, including carry trade, as it determines whether these strategies can function at all.