The buffer between market shocks is eroding in the Treasury markets
Many investors fear that the gradual withdrawal of participants from a Federal Reserve program that has helped the US government reduce its borrowing costs would lead to greater fluctuations in the $26 trillion Treasury market and higher interest rates.
On Wall Street, the overnight reverse repurchase facility is called reverse repo. It allows money-market funds and other large financial organizations to temporarily trade excess cash for high-quality assets on the central bank’s balance sheet, while also pocketing interest. Over the past few years, the Federal Reserve’s program has seen heavy use, with daily balances dropping from $2.5 trillion to below $500 billion.
The continued drop in program utilization, according to many analysts and portfolio managers, will limit the market’s ability to absorb shocks in the U.S. Treasury securities market. Lower program balances, according to observers, might lead to further volatility and a new spike in interest rates in the market that supports the world’s financial system, which means the government is facing higher interest expenses as it tries to pay a mounting deficit.
The market absorbs bill supply more easily when there is a huge quantity of cash waiting to be deployed, according to Michael de Pass, global head of rates trading at Citadel Securities.
Unobscured as it may seem, reverse repo has always been fundamental to how the US economy and banking system function. Last fall, a Treasury advisory committee proposed that the Federal Reserve’s mountain of money-market funds could be used to issue a deluge of short-term bills. This unconventional strategy has allowed the government to maintain relatively low long-term interest rates, even though the pace of U.S. debt issuance has been increasing.
During the epidemic and again in 2023, sales of one-year or fewer Treasury bills increased. Since the end of 2017, the market value of T-bills has increased from less than $2 trillion to nearly $6 trillion.
While it may appear to be a technical advancement, it has far-reaching consequences for anyone involved in the international bond market. Concurrent with the Fed’s hikes to benchmark interest rates, all of this short-term debt will have to be refinanced at higher rates. While selling bills is a quick way for the government to get cash, it will be tough to acquire funds again when the payments are due.
Since interest payments are quickly becoming the biggest expenditure in the government budget, many bond investors believe that the Treasury Department will soon need to figure out how it intends to pay its bondholders in the long run.
At least for the time being, investors are satisfied with the U.S. By selling an abnormally large quantity of bills in November, the Treasury Department allayed market anxieties that demand for U.S. debt was declining, so avoiding buyers’ concerns about the limits of investor demand for long-dated Treasurys.
The Federal Reserve has seen the decreased utilization of the reverse repo facility as an encouraging indicator that surplus funds are being reallocated to more appealing market possibilities. The Federal Reserve anticipates that banks will start to lose reserves once reverse repo has been mostly used up. Reserves are a kind of electronic cash that banks employ to handle transactions involving themselves, their clients, other banks, and the central bank.
To counterbalance the central bank’s efforts to tighten banking conditions in an effort to cool the economy and, by extension, inflation, money-market funds have withdrawn funds from reverse repo and reinjected them into the economy. Government officials are keen to keep reserves from getting significantly lower, since this would raise the possibility of problems in the multitrillion dollar cash markets, which may have a domino effect on the entire financial system. The 2008 financial crisis, the Federal Reserve’s attempt at quantitative tightening in 2019, and the start of the COVID-19 pandemic are all very much on people’s minds. In order to keep an eye out for possible pressures, the Federal Reserve is anticipated to ease up on quantitative tightening this year.
A smaller reverse repo cash pile isn’t always a dealbreaker, in everyone’s opinion.
“Bills can be a plug for the government, as financing needs move around based on tax collections and spending needs,” quipped Jason Granet, chief investment officer at BNY Mellon. “In this kind of climate, people typically desire more Treasurys, even in the event of a recession that necessitates increased government spending.”
A large portion of the reverse-repo flows can be attributed to the unprecedented amount of capital that investors have poured into money-market funds. These funds currently possess assets valued at over $6 trillion. Money funds stashed part of the influxes at the Fed, where they were limited to highly rated short-term assets like repurchase transactions and Treasury bills. Working overnight with the most reliable counterparty in the market now yields an annualized rate of 5.3%.
According to RBC Capital Markets’ head of U.S. rates strategy Blake Gwinn, the Federal Reserve’s reverse repo facility is expected to retain a balance of around $100 billion to $200 billion in the long run. In the event that the Federal Reserve lowers interest rates, it will promptly start paying reverse repo investors less. It is also helpful to have a way to get money quickly.
The expense of funding the government over a 10- to 30-year period is something that the Treasury considers with a very long time horizon, according to Gwinn. “It seems unlikely that they’re worried about the decline in demand for bills.”
