Tuesday, June 6, 2023
It seems like Treasury investors can’t catch a break. Last week, investors were concerned about a U.S. default (not a real risk, in our view) and this week, there is a lot of focus on the glut of Treasury issuance coming to market now that the debt ceiling drama is behind us. So should investors be worried? We don’t think so, but first, the specifics.
As part of the deal, the Treasury Department has unfettered borrowing capacity until January 2025. And borrow it plans to do. After draining its primary general account to keep paying its obligations, the Treasury is expected to issue at least $1.1 trillion in net new Treasury bills (T-bills) over the next few quarters to replenish its account as well as fund normal government operations. So, with that much issuance expected over a relatively short time horizon, the questions really become what impact will that have on T-bill prices and what impact will that have on general market liquidity?
Regarding the impact on T-bill prices, historically, T-bills, which have maturities of up to one year, have been easier for the market to digest. In fact, there’s been very little correlation between supply and prices. So, while issuance will be supersized this time around, we don’t expect meaningful disruption in the T-bill market.
The impact on market liquidity, however, could be a bigger risk. There are three primary domestic buyers of T-bills: banks, nonbanks (mostly households), and money market funds. Of those three primary buyers, nonbanks and money market funds can most directly impact market liquidity. So, with the amount of T-bill issuance coming to market, the impact on market liquidity will depend on who the primary buyers will be. However, as seen on the chart below, there are two avenues in which liquidity will be impacted: bank reserves and assets held at the Federal Reserve’s (Fed) overnight reverse repo facility (ON RRP).
Bank reserves represent the minimum amount of deposits a bank must have on hand. And when bank reserves fall below a certain threshold, bank lending is impaired. Nonbank investors generally fund purchases through the bank reserves channel. The Fed’s ON RRP facility allows certain money market funds to borrow from or lend to the Fed, using government securities as collateral, and agreeing to buy or sell back those securities at rates set by the Fed, on an overnight basis. This channel has very little impact on market liquidity.
So, if the primary buyer base is nonbank investors, bank reserves will drop. And given the earlier regional banking concerns and the ongoing concerns around “deposit flight”, if bank reserves fall too much, it could negatively impact the economy and markets. However, if the primary buyer base is money market funds, the impact would be negligible. Certainly, the buyer base will be a mix of both (plus non-U.S. investors that will not impact market liquidity either) but according to analysis from Deutsche Bank, its baseline scenario is that ON RRP drainage starts at 40% of the overall liquidity reduction over the next few months and accelerates to 60% in the fourth quarter and 80% in 2024. That would put reserves at around $2.5 trillion, which would not represent a level that would be deemed concerning for the Fed. In fact, this is consistent with Fed expectations.
Bottom line is that as long as U.S. Treasury securities are regarded as risk free securities, there is always going to be demand for T-bills. The questions though are at what price and who will those buyers be? In our view, there is currently an abundance of liquidity in the market that can be used to absorb the glut of issuance coming to market in the next few quarters without a disruption to prices or liquidity.
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