Mounting Treasury-bill supply is creating a “narrow and difficult” path for the Federal Reserve to keep unwinding its massive balance sheet and avoid roiling funding markets, according to Barclays Plc.
(Bloomberg) — Mounting Treasury-bill supply is creating a “narrow and difficult” path for the Federal Reserve to keep unwinding its massive balance sheet and avoid roiling funding markets, according to Barclays Plc.
The key question is where the money will come from to absorb the hundreds of billions of dollars of bills the Treasury is selling in the wake of the debt-ceiling resolution in June. Along with Fed interest-rate hikes, that burst of issuance is driving up bill yields and luring cash from across the financial system.
The likely scenario, Barclays says, is that the money will continue to come mainly from a key Fed facility. But the firm also sees a risk that it drains bank reserves to the point that they become scarce, upsetting the market where banks obtain short-term financing. It’s an issue that will only grow in importance as Barclays expects the Treasury to sell an additional $940 billion of bills by year-end, pushing bill yields even higher.
“The Fed’s path toward a soft landing for its balance sheet is narrow and difficult,” strategist Joseph Abate wrote in a note to clients Tuesday.
The Treasury plans to end the year with $750 billion in its account at the central bank, up from about $550 billion now. The complication is that it’s not clear how much faster money will leave the Fed’s overnight reverse repurchase agreement facility, or what level of reserves banks are comfortable holding. Barclays estimates that there’s about $400 billion separating bank reserves from the scarce level that caused repo rates to spike in September 2019.
For more than a year, the Fed has been working to reduce its balance sheet by letting some maturing bond holdings roll off, a process known as quantitative tightening. The pile is now $8.24 trillion, down from $8.91 trillion in May 2022. The program is leading the US government to boost borrowing, and until now much of the increase has been through bills.
Money-market observers, with the 2019 episode in mind, have been fixated on where the cash is flowing in from to absorb the supply flood.
One source is the Fed’s reverse repurchase agreement facility. At one point that pile dwindled to $1.74 trillion from more than $2 trillion at the beginning of June. The other potential source is the $3.17 trillion of bank reserves parked at the Fed — more problematic because of the risk of reserve scarcity.
“With the TGA set to rise another $200bn by year-end and a high degree of uncertainty about the RRP (which could be worth at least a few hundred billion dollars), the path to a soft landing for QT and the Fed’s balance sheet is indeed narrow and difficult,” Abate wrote.
Treasury has already issued roughly a net $799 billion of bills from the beginning of June through July, with plenty more to come. Investors have easily digested the first wave of supply, with money-market mutual funds taking roughly two thirds of the issuance by yanking $430 billion from the Fed’s overnight reverse repurchase agreement facility.
Abate says the higher bill yields and the resulting dealer balance-sheet congestion will be enough to pull additional cash out of the RRP — with usage dropping to $1.2 trillion by year-end. But he says there are still questions around how much RRP usage will fall, as seen when the drain from that facility stalled in July.
At the same time, Barclays said bank demand for balances at the Fed has likely increased since the sector’s turmoil in March and that makes it harder to pinpoint the system’s lowest comfortable level of reserves. The hope is that market participants continue absorbing the deluge of bill supply and draining the RRP, leaving bank reserves at ample levels.
Fed Chair Jerome Powell said in June that QT is unfolding mainly in the RRP and poses no imminent threat to the level of bank reserves.
“Whether the Fed can avoid accidentally triggering reserve scarcity through QT depends on RRP balances falling faster than the Fed’s asset roll-offs,” Abate wrote. “In turn, this depends on the willingness of money funds to increase their bill allocations.”
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