The biggest risk to the stock market in 2024 may be a liquidity shock from the Fed

• One of the biggest risks to the stock market in 2024 is the Federal Reserve's balance sheet reduction program.
• Ned Davis Research said the Fed could spark a liquidity shock as Treasury issuances remain high.
• "Powell has pledged that quantitative tightening will continue unless the economy collapses," NDR said.

While the stock market catapults to new all-time highs to close out 2023, there is still one big risk that is lurking in 2024, according to a Tuesday note from Ned Davis Research.

That risk is the the shrinking of the Federal Reserve's balance sheet to the tune of almost $100 billion per month, which could spark a liquidity crisis as Treasury issuances remain high.

"One of the biggest macro risks for 2024 is the continued reduction of the Fed's balance sheet or quantitative tightening (QT)," NDR warned.

So far, the Fed has reduced its balance sheet by nearly $1.3 trillion from its $9 trillion peak in 2022. But the bulk of that reduction has been from the Fed reducing its usage of the reverse repo facility, resulting in a minimal net impact on reserves US banks hold at the Fed, according to NDR.

"Effectively, the shrinking of the Fed's balance sheet has had no effect on banking liquidity! No wonder why we are having a tough time seeing the impact of the Fed's tightening cycle on the real economy," NDR said.

That's because the reverse repo is simply the Fed selling a security and agreeing to buy it back at a future date. But when the Fed moves past reducing its usage of reverse repos, it is bound to reduce its balance sheet via reserves held by US banks. About half of the Fed's balance sheet is made up of deposits from US banks.

But that's set to change in 2024, and it could lead to a sharp decline in liquidity that will ultimately impact the stock market in a negative way.

"If the Fed keeps going with QT and the Treasury keeps issuing a ton of Treasury bills (both pretty good bets), the Reverse Repo Facility will go to zero, probably sometime in Q2. At that point, QT will begin affecting bank reserves, draining the market of liquidity. That won't be a happy time for the markets," NDR said.

A decline in liquidity will also limit banks' appetite to give loans to businesses and consumers, restricting the growth of the economy. Unless the Fed scales back QT, consider liquidity a big risk for markets in 2024.

"Powell has pledged that quantitative tightening will continue unless the economy collapses," NDR said, pouring cold water on the idea that the Fed might end its balance sheet reduction program. 

Liquidity conditions for Treasury bonds are not showing good signs due to the sharp rise in issuances this year amid big budget deficits and a near-government shutdown. NDR said this could hurt the stock market over the next week.

"The Treasury will be auctioning 2s, 5s, and 7s next week, along with its regular supply of bills. That has resulted in liquidity conditions that are near the worst levels since the pandemic. Next week could see some wild volatility," NDR said.