After abundant liquidity buoyed markets in the first part of 2025 despite economic uncertainty, liquidity conditions are now at a critical juncture that could set the course for either a deflationary or inflationary path in the coming months and into 2026. According to Economist Andrew Hunt, understanding the nuanced flow of funds in the financial system is key to navigating the risks and opportunities ahead.

The elevated liquidity that supported "Teflon markets" in early 2025 stemmed from factors like a widening U.S. current account deficit and limited Treasury issuance due to the debt ceiling. This allowed banks to recycle deposits into lending and speculation, weakening the dollar.

However, with the debt ceiling now raised, U.S. Treasury issuance is starting to ramp up, particularly in short-term bills. The key question is whether this new issuance will be absorbed without disruption. Money market funds, a major buyer of bills in 2023, are now fully invested. Crypto stablecoins, another potential source of demand, are not growing assets fast enough to matter in a flow sense. This leaves banks as the crucial actors - if they aggressively expand balance sheets to buy bills and exploit arbitrage opportunities, the "pain-free" issuance narrative holds. But early indications are banks are not showing much appetite so far.

If banks pass on bills and we see more "crowding out" of other borrowers in commercial paper and repo markets, liquidity could quickly shift from accommodative to restrictive, threatening risk assets and leverage. Softer economic data, reflecting payback from pre-tariff stockpiling in Q1, amplifies the dangers. Ironically, dollar shorts may have to cover, sparking a rally.

Central bank reaction to any such stress is critical. The ECB and BOJ are already easing, and the Fed would likely cut rates quickly if U.S. markets wobble. This could steepen yield curves, enticing banks to ride the curve and expand balance sheets, generating a "QE-like effect" and sparking a year-end rally.

The problem is easing when output gaps are positive and inflation expectations are already picking up. If authorities ease aggressively and the public sees a rerun of the pandemic stimulus and resulting inflation, they may seek to get ahead of it via wage demands and price hikes. Trust in governments is low. In this scenario, easing might not boost growth much but could stoke a serious inflation outbreak.

Japan bears close watching as a canary in the coal mine. Its public may be losing faith in the central bank after years of extreme QE. Households are running down cash deposits and borrowing yen, "shorting the end." If this spreads globally, it has profound implications.

Key signposts in the coming weeks will be Treasury issuance levels and bank balance sheet responses. Into 2026, watching broad public inflation expectations and demands will be critical. Overall, investors are well-advised to stay close to benchmark until the fog clears. The liquidity tide is turning, but whether it ebbs slowly or rushes out depends on these crucial actors.

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