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Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Macro update: Contrary to Market Expectations, Data Shows Mitigated Liquidity Impact as US Treasury Refills General Account
Redmond Wong
Chief China Strategist
Summary: The latest data contradicts the anticipated liquidity drain as the US Treasury replenishes its General Account (TGA) at the Federal Reserve. Analysis reveals that money market funds' purchase of Treasury bills using reverse repo balances has mitigated the liquidity impact. The data shows that a reduction in overnight reverse repo balances counterbalanced the TGA increase. Moreover, bank reserves at the Federal Reserve were nearly unchanged, indicating no contractionary impact on banking system liquidity.
The background
Following the enactment of the debt-ceiling bill on June 3, the US Treasury has unveiled its plan to increase the cash balance in the Federal Reserve's Treasury General Account (TGA). While market participants have expressed concerns about the potential impact on liquidity within the banking system and derailing the equity market rally, we have been arguing that much of the potential liquidity drain might be mitigated by money market funds deploying their reverse repo balances at the Fed to buy Treasury bills. An analysis of the latest data validates our hypothesis and suggests that the prevailing fear may be overblown.
Examining the TGA increase and its impact
The magnitude of the perceived impact hinges on the source of the TGA increase. It is crucial to assess whether it arises from a reduction in bank excess reserves, depleting banking liquidity, or a decrease in the reverse repo balances of the money market fund at the Fed, which would transfer liabilities on the Fed's balance sheet without affecting banking liquidity.
When investors were to withdraw funds from their bank accounts to purchase the newly issued Treasury bills, subsequently leading to the Treasury depositing the resulting proceeds into the TGA, it will lead to a reduction in the banking system’s reserve balance at the Federal Reserve. For example, if the Treasury issues USD10 billion T-bills and investors buy the T-bills by using the money in their deposit account at commercial banks, it will cause a decline of USD10 billion in deposit (liabilities) and a fall of USD10 billion in reserve at the Federal Reserve (assets) of the US banking system’s balance sheet (Figure 1) and results in a USD10 billion decline in liquidity in the US banking system.
However, many of the investors who buy T-bills are money market funds. Money market funds typically invest in two major asset classes: T-bills and reverse repos with the Fed. These reverse repurchase agreements, or reverse repos, are overnight lending from the money market funds to the Fed and the Fed gives the money market Treasury securities as collateral and pays an interest currently at 5.05%.
Therefore, when money market funds buy Treasury bills in the auction from the Treasury by reducing their reverse repo lending to the Fed, the liquidity of the banking system would remain unaffected as the Treasury deposits the acquired funds into the TGA at the Fed. (Figure 2)
TGA increase has not affected liquidity in the banking system
Examining the latest data from the Federal Reserve H.4.1 report offers valuable insights into the developments surrounding the Treasury General Account (TGA). The report indicates a significant increase of $243.6 billion in the TGA, rising from $48.5 billion on May 31, 2023, to $292.1 billion on June 21, 2023. However, it is essential to note that this increase was nearly offset by a $217.8 billion decrease in the overnight Reverse Repo balance at the Fed during the same period, dropping from $2,254.9 billion to $2,037.1 billion. This tends to support the hypothesis that money market funds have been reducing overnight reverse repos with the Fed and using the money to buy Treasury bills.
In this process, the increase in the TGA balance has not affected liquidity in the banking system. In fact, US banks' reserves in the Federal Reserve system were almost unchanged at $3,204 billion on June 21, from $3,205.5 billion on May 31, countering concerns over liquidity drain.
Figure 3 and Figure 4 below illustrate the changes in the TGA balances, overnight reverse repo balances, and reserves held by banks at the Fed.
Shifting investment preferences as the Fed makes a pause
Driven by the Federal Reserve's decision to postpone a rate hike in June and market expectations of only one more hike before the cycle concludes in July, money market funds have exhibited a preference to shift funds from overnight reverse repos to capitalize on the higher yields offered by Treasury bills. With the Fed currently paying an overnight interest rate of 5.05% to money market funds, the investment rates on Treasury bills, ranging from 5.113% to 5.511% in recent auctions, present an attractive alternative. This shift in investment preferences not only reduces exposure to reverse repos but also mitigates potential liquidity concerns.
The dissipation of liquidity risks supports the equity market
Upon reassessment, the initial fears surrounding the impact of the Treasury's cash balance strategy on banking system liquidity appear exaggerated. The latest data indicates a more balanced dynamic, with offsetting factors contributing to maintaining adequate liquidity levels. While vigilance remains crucial, particularly in monitoring the sources of TGA funding and their implications for market dynamics, it is reasonable to expect the absence of a feared liquidity crunch will contribute to supporting the equity market.
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