With the US debt ceiling standoff defused, the Treasury can start borrowing big money again. The government is forecast to issue up to $1 trillion of debt this year in short-term bills, sucking cash out of the US financial system.
This has some bank analysts and market strategists fretting about the dangers to financial stability and the valuation of stocks or other risky assets, especially as the Federal Reserve continues to shrink its balance sheet, unwinding its ultra-loose monetary policies at the same time.
The road could indeed be bumpy. Banks are going to see margins squeezed as they are forced to pay more for deposits. The value of risky assets is going to be hurt by the growing supply of safe US government debt paying decent yields. But lack of liquidity isn’t going to ruin either banks or markets.
The reason: There’s one big pressure valve – and it will either work automatically or the Fed can tweak it any time to ease any strains. It is the reverse repurchase facility, or RRP, that money market funds have been using to park trillions of dollars of spare cash outside of the banking system. All of this money is available to wash back in at the right price as interest rates through the financial system.
To explain, let’s start with the Treasury. During the debt ceiling standoff, the US government kept spending with tight limits on its ability to borrow, which meant running down the balance of its bank account. The Treasury General Account, which is held at the Fed, has declined from almost $1 trillion this time last year to recent lows of less than $50 billion.
The Treasury wants to rebuild its bank balance so it has spare cash to deal with sudden surprises. It aims to raise it to $450 billion by the end of June and $600 billion by the end of September. Some analysts expect it will aim to get higher still by year-end.
All this fresh borrowing is ultimately paid for by savers and investors with their own bank deposits. But what actually happens is those deposits cease to exist and banks pay the Treasury for the bonds using reserves, which is a special kind of money used only by the Fed, Treasury, and the banks themselves.
Reserves are closely followed by some market watchers: Trillions were created by quantitative easing and the Covid-pandemic era support for finance, people, and companies. As hundreds of billions disappear from the banking system again, it is like suddenly withdrawing that support, which gets some investors nervous.
However, there are $2.5 trillion of spare reserves sitting on the sidelines, which could fund most or all of what the Treasury needs. This money — on the Fed’s balance sheet in the RRP — was put there by money market funds unable to earn decent returns elsewhere. This RRP facility was deliberately redesigned by the Fed in early 2021 to give the market somewhere to put spare cash, as I wrote about in January. It needed to do this to stop money funds from chasing short-term yields down to levels far below where the Fed was setting interest rates.
Money funds lend their spare cash to the Fed and take Treasuries as collateral – and the effect is similar to the government selling short-term bills: Bank deposits disappear and reserves are handed to the Fed.
The current rate paid on the overnight RRP is an annualized 5.05%, which is slightly less than the 5.15% that banks earn parking money with the Fed. The RRP rate is designed to limit how low rates can go in financial markets: If there is too much money chasing Treasury bills or being loaned out by money funds in private repo markets, yields get crushed. So long as the RRP offers an attractive minimum rate, excess cash in the system should find its way there because there’s no point storing it elsewhere for less.
The huge amounts of money created during the Covid crisis alongside fewer other options for safe short-term investments drove those RRP balances to $2.8 trillion at their peak. Now the government is issuing so many bills, as long as they yield above 5.05%, they ought to attract money from the RRP back into normal markets.
There are some wrinkles, however, which explains the range of forecasts: Barclays Plc strategists expect most of the money for the Treasury to come out of RRP; at the other end of the scale JPMorgan Chase Inc. expects bank reserves to drop dramatically.
First, money funds might prefer to keep a lot of their cash in the overnight facility while interest rates could still rise further: There is a cost to buying bills with a maturity of one month or three months if you think rates will rise in that time.
Second, if money funds do behave like this, then the coming bill issuance will suck reserves out of the banking system. That could lead to strains for smaller banks that are already having to compete hard to retain deposits. It could also cause issues in private short-term repo markets where dealers and hedge funds borrow money against Treasurys: In September 2019, repo rates spiked higher when declining bank reserves met a big wave of bill issuance and tax payments.
But this seems unlikely to be a major problem either. Repo rates, or the Secured Overnight Financing Rate, have been tracking the RRP rate very closely. If SOFR starts to rise, it ought to draw more money out of the RRP too — after all the collateral is exactly the same.
Lastly, if distortions do start to appear the Fed can change the terms of the RRP again, cutting the rate it pays to make it much less attractive and capping the amounts of money it will take in. That would force money market funds to move their cash elsewhere.
Rising rates will keep causing issues for banks, borrowers, and financial markets – after a decade-plus of near-zero rates, it could hardly be otherwise. But the coming wave of Treasury bill issuance is not the deathtrap some might fear.
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