Capital Flows in a High-Reserve World: Where Liquidity is Being Absorbed

The macroeconomic setup is defined by a fundamental tension. On one side, central banks have engineered an ample supply of reserves. On the other, capital isn't flowing smoothly into traditional assets. This is the structural puzzle of our era: liquidity is abundant, but its destination is unclear. The search for a stable home is complicated by two competing forces-one pushing reserves higher, the other pulling capital away from conventional markets.

The first force is a structural increase in the demand for bank reserves themselves. The Federal Reserve's current floor system, which pays interest on reserves to manage short-term rates, requires a sizable balance sheet to function. But the threshold for "ample" is not static. Evidence suggests that changes in deposit composition and regulation since the pandemic have raised the baseline demand for reserves, effectively increasing the amount of liquidity needed to keep the system stable a simple econometric analysis confirms our conjecture. This means the Fed's quantitative tightening efforts are not simply about reducing total reserves, but about navigating a higher equilibrium level of liquidity. The system is designed to absorb this, but it creates a permanent, elevated floor for market liquidity that wasn't present before.

The second force is the diversion of capital to less traditional or less liquid assets. This is evident in the recent trajectory of global liquidity and growth. In the first half of 2025, a massive surge in liquidity fueled a powerful equity rally. Yet, recent data suggests both growth and liquidity may now be peaking economic growth appears to be slowing and liquidity looks to be nearing a peak. As the easy-money fuel runs out, the rally loses momentum. This sets the stage for a market where gains become harder to sustain, shifting focus from multiple expansion to underlying earnings-a dynamic that favors quality and resilience over speculative bets.

Compounding this puzzle is the weakening of the U.S. dollar, which reflects a broader reallocation of capital. The dollar fell sharply in the first half of 2025, driven by slower U.S. growth, fiscal concerns, and policy uncertainty rather than simple rate differentials slower U.S. growth, rising deficits, policy uncertainty and changing global capital flows. A key signal is the shift in foreign investment flows. Net inflows into U.S. equities have weakened significantly, with European investors notably rebalancing toward local assets European-focused ETFs domiciled in the region receiving a record $42B in net flows YTD. This isn't a flight from the dollar's reserve status, but a strategic diversification that pressures its value and complicates the search for a single, stable home for global capital.

The bottom line is that liquidity is being absorbed in multiple places at once. It's being held as higher-demand reserves within the banking system, it's being deployed in a final, peak-driven rally, and it's being redirected by global investors seeking alternatives. This fragmentation creates a more complex and potentially volatile environment for all asset classes.

Destination 1: Private Equity – High Rates, Long Holds, and a Liquidity Crunch

The new monetary environment is forcing a painful recalibration on private equity. The sector's traditional playbook-buying assets, improving them, and selling for a profit-is under severe pressure from a dual assault of high interest rates and extended holding periods. This isn't just a margin squeeze; it's a fundamental shift in the math of returns.

The core challenge is that achieving target internal rates of return now demands twice the operational performance. To hit a 20% IRR with a 7% interest rate and a seven-year hold, sponsors need . . The implication is stark: each fund must now create twice the enterprise value to deliver the same outcome. This recalibration is pushing sponsors to focus intensely on pricing power, strategic transformation, and embedding operational efficiency-levers that are harder to pull in a slowing growth world.

This pressure is creating a dangerous feedback loop. On one side, the sector is seeing a surge in activity, with . On the other, the need to realize those investments is mounting. Exits remain challenging, increasing pressure on sponsors to actively manage aging portfolios. The result is a tension between the desire to deploy capital and the high cost of holding it. This dynamic is further complicated by short-term uncertainty, as tariff turmoil has held back deals and exits in recent quarters, forcing firms to accelerate full exits to improve liquidity.

The bottom line is that this environment risks limiting the very capital recycling that fuels the private equity engine. With higher costs to hold and a compressed exit window, the sector may struggle to deploy its full war chest. This constrains new investment and slows the flow of capital back into the broader market, turning a liquidity crunch within a specific asset class into a broader systemic headwind.

Destination 2: Real Estate – A Frozen Market Seeking a New Equilibrium

The higher-for-longer interest rate backdrop is freezing the traditional housing market, creating a structural shift in capital allocation. Mortgage rates are expected to ease only slightly to , a level that continues to suppress demand. J.P. , but that modest growth is occurring against a backdrop of exceptionally low activity. Existing home sales and inventory remain near record lows, indicating a severe demand issue rather than a supply shortage Demand - often understood through existing home sales (EHS) - remains exceptionally low. The market is effectively locked in, with over 80% of borrowers significantly underwater on their mortgages, creating a powerful disincentive to sell and freeing up housing stock.

This stagnation is a direct headwind for yield-driven real estate assets. As access to easy money further diminishes, the cost of capital for property investment rises, compressing returns across the sector. The dynamic is clear: a market where demand is structurally suppressed by high borrowing costs is ill-suited for capital seeking stable yields. This pressure is compounded by the broader economic slowdown, which reduces rental demand and property income. The result is a real estate market seeking a new equilibrium, one that will likely involve lower prices, higher yields, and a significant reallocation of capital away from traditional property into other asset classes that offer better risk-adjusted returns in this environment.

Destination 3: Bonds – Volatility and a Search for Safety

The Treasury market remains the ultimate liquidity sink, but its stability is now a more critical and fragile factor in the global capital flow. As the world's largest securities market, it serves a dual purpose: it is the primary safe-haven asset for global investors and the essential tool for the Federal Reserve to implement monetary policy The U.S. Treasury market is the largest securities market in the world. This makes its smooth functioning a linchpin for the entire financial system. When its liquidity falters, the entire capital allocation process is disrupted.

Recent evidence shows this system is not immune to stress. In April 2025, the market experienced a brief but notable deterioration in liquidity, triggered by abrupt trade policy shifts liquidity briefly worsened around the April 2025 tariff announcements. Measures like bid-ask spreads and order book depth widened and contracted, mirroring the volatility seen during past crises like the 2020 pandemic and the 2023 banking turmoil. The key takeaway is that while the stress was contained and liquidity quickly recovered, it highlights the vulnerability of this critical infrastructure to geopolitical and policy shocks. The market's relation to volatility has been consistent with historical patterns, but the sheer size of the market means even temporary friction has amplified ripple effects.

This dynamic underscores a broader capital flow. Despite the dollar's recent weakness, capital is still flowing into dollar-denominated assets. Data from the Bank for International Settlements shows that foreign currency credit in dollars grew by . This growth, , indicates a persistent demand for U.S. dollar assets, even as the currency depreciated. The trend reversed from 2020 to 2024, when credit growth to U.S. residents outpaced that to non-residents. This shift suggests a strategic reallocation, with global borrowers and investors seeking the relative safety and depth of dollar markets.

The bottom line is that the Treasury market is absorbing capital, but its role as a safe haven is now intertwined with heightened volatility. Its stability is paramount, as any significant disruption would force a chaotic reallocation of capital away from the world's most liquid asset. For now, the market is holding, but the April 2025 episode is a reminder that its function as a liquidity sink is not automatic-it requires a stable policy and geopolitical environment.

Catalysts and Scenarios: Navigating the New Reserve Regime

The path forward hinges on a few critical signals. The Federal Reserve's transition to an "ample reserves" regime is not a one-time event but an ongoing calibration. The pace of its balance sheet runoff and any adjustments to its quantitative tightening framework will be the primary indicator of whether the system is finding its new equilibrium. The Fed's own outreach suggests this is a live policy debate, with officials relying on market intelligence to understand developments We rely on our interactions with primary dealers... to help us better understand market developments. The key question is whether the Fed's target for "ample" liquidity is static or dynamic. Evidence points to a dynamic threshold, as changes in deposit composition and regulation have raised the baseline demand for reserves a simple econometric analysis confirms our conjecture. If reserve demand continues to rise, the Fed may need to slow its runoff or even pause, altering the entire liquidity narrative.

At the same time, the trajectory of global liquidity and U.S. economic growth will determine the pressure on risk assets. The recent equity rally was a direct function of a massive liquidity surge, but that fuel may now be running out. Data suggests both growth and liquidity are nearing a peak economic growth appears to be slowing and liquidity looks to be nearing a peak. A sustained slowdown would shift market dynamics decisively. Gains would then depend more on earnings growth than multiple expansion, favoring quality and resilience. This would weigh on high-beta stocks, high-yield credit, and other yield-driven assets like real estate, as access to easy money further diminishes.

Finally, private equity activity serves as a leading indicator of corporate capital allocation and overall market liquidity. The sector's deal economics are a direct reflection of the high-cost environment. While deal value hit a record , the need to achieve returns has doubled, demanding twice the operational performance . This creates a tension between deploying capital and the high cost of holding it. Early signs show tariff turmoil has already held back deals and exits, forcing firms to accelerate full exits to improve liquidity tariff turmoil has held back deals and exits. Monitoring exit activity and deal economics is therefore crucial. A sustained slowdown in private equity could signal a broader capital recycling freeze, constraining new investment and slowing the flow of capital back into the broader market.

The bottom line is that the new reserve regime is defined by interlocking signals. The Fed's balance sheet path sets the stage, global growth and liquidity determine the risk appetite, and private equity's behavior reveals the health of corporate capital allocation. Navigating this environment requires watching all three.