COVID | Monetary Policy & Inflation | Rates | US
Over the last five years, the Treasury decided to maintain large cash balances at the Fed for a variety of reasons. However, those levels have jumped off the charts post the COVID-19 fiscal stimulus response. We go back and look at the interplay of the TGA and RRP versus the evolution of flows in money markets. In my view, the Fed/Treasury response satiated the mad dash for cash. Now comes the hard part of prying some of that money away and encouraging it to move out the curve and into risker assets ahead.
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Over the last five years, the Treasury decided to maintain large cash balances at the Fed for a variety of reasons. However, those levels have jumped off the charts post the COVID-19 fiscal stimulus response. We go back and look at the interplay of the TGA and RRP versus the evolution of flows in money markets. In my view, the Fed/ Treasury response satiated the mad dash for cash. Now comes the hard part of prying some of that money away and encouraging it to move out the curve and into riskier assets ahead.
TGA/RRP Liquidity Outside The Direct Control Of The Fed, So Give Them T-Bills
There is a disproportionately large amount of cash sitting in the Treasury General Account (TGA) versus historical levels and even versus the Treasury’s own supersized forecast. In fact, the first TGA estimate for June 30th was $400bn, and then it was revised to $800bn. But current levels are well over $1.4tn! The clock is ticking to hit its June 30th target which is highly unlikely (and in the grand scheme of things it will result in a major cost if they do not). But something doesn’t add up when looked at via a traditional lens.
Meanwhile the Fed has done all in its powers to avoid the mad dash for cash that I warned about in early March before they rolled out all these programs. Our concern back then was that as investors de-risked their cash would end up sitting on the Fed balance sheet via money funds using the RRP. It would effectively drain liquidity, something that the Fed would not want to happen at this point in the cycle.
As we discussed in our most recent money market update, the Treasury leaned on T-bills to raise cash quickly during the early days of the US government’s response to COVID-19 fiscal stimulus needs. This also helped fill a need as both institutional and retail investors were shifting funds into money markets (as there was demand for liquid assets and again this would help avoid encumbering the Fed’s balance-sheet via RRP). During the heat of the crisis it would not have made sense for the Treasury to issue long-term bonds as that would have added to the vol., even if the Fed would have ultimately end up buying them. Give the people what they want, and they want T-bills – even now as fund balances remain high.
Institutional Flows Are Key For The Next Liquidity Moves In Other Assets
This brings us to the main visual aid of this report. Chart 2 is full of history and cross-reference points that highlight what drove investors to flood periodically into money market funds over the last 15-plus years. There is a lot to digest here – so let’s zoom in and out. The first glaring observation is that with each new crisis the speed at which things happen increases. Second, there is a predictable pattern in which institutional funds move first and then wait it out to see if the Fed has provided enough support to engender a true recovery for both the economy and the financial markets. Third there seems to be multiple moves before confidence is returned, its these echo moves that we are still waiting for today.
To put things into perspective, during the early days of the GFC, institutional funds were already getting cautious post the credit and money market fund issues that surfaced in the summer of 2007. As seen in the left side of the chart, even after the Fed cut rates back then and introduced new liquidity programs like the Term Auction Facility (TAF, which was not re-launched this time likely because PDCF and repo has been working well), institutional investors kept moving more cash into money funds. In fact, all throughout 2008 institutional money was growing in a wave and then all of a sudden slowed down after the Fed put in place a series of new liquidity measures and providing lending for the BSC/JPM deal. The rest is history but it’s important to note that institutional folks only tapped into this cash post QE1 event.
As I have said before, in many ways GFC was a trial run for the Fed and Treasury’s current capabilities in combating this crisis. Back then, before the Fed had experience using IOER and RRP, the Treasury used to direct deposit cash via a program called the Supplementary Financing Program (SFP). This was where the Treasury issued T-bills specifically for the explicit purpose of assisting the Fed during the early days of its balance-sheet expansion. That is the green line you notice in the chart spiking to $600bn during the height of the GFC crisis period in 4Q08. In many ways, SFP back then was a modified version of what the Treasury is doing now with its TGA. They probably figured it’s easier to do this via TGA versus re-launching the SFP – plus we have way too many acronyms now for the public to have to understand!
In 2008 the Fed’s balance sheet expanded first via the liquidity programs because that was where the issues were in the banking system. What makes this crisis different from 2008 (besides being faster and larger in magnitude) is that the Fed focused a majority of its efforts in the Treasury market first and to a much greater degree in terms of the actual amount of money it threw at taking down notes and bonds versus offering just pure liquidity programs. This time there were three reasons why this happened.
One, we were still dealing with the repo issues and bloated dealer balance sheets heading into this crisis Two, foreign holders of US Treasuries sold record amounts in March as they needed to tap USDs (during the COVID-19 impact on the global economy). And three, given that the US government had to quickly support large segments of the economy and issue record amounts of securities to finance fiscal stimulus, the Fed was the only entity that could expand balance sheet at a quick enough pace to facilitate this.
What Will It Take For TGA To Shrink And What Are The Market Implications?
TGA can naturally decline as the US government disburses more funds via its fiscal stimulus programs and/or if Treasury lets some cash roll off. It also can shrink if demand for money market funds decline which would then take pressure off of those having to seek out high quality liquid assets like T-bills. In the very short-run, there are counterforces too. For example, on the margin those making payments on their upcoming 7/15 income tax returns can see further cash make its way to the US government too.
Now of course it’s always possible that this money on the side-lines is there for a reason as many investors are unconvinced that the economy will bounce back enough to justify valuations in riskier assets. If we take a look at Chart 2 once more, we see that there was a repeat spike in flows into 2009. If there is a second wave of COVID-19 and the economy doesn’t rebound as strongly as priced into assets, there is a risk of a repeat of something similar to what happened between the BSC thru LEH period.
In the end we need to follow the money. But in this case what that really means is follow the money market flows. And one more thing, the Treasury will need to continue to term out its debt as there is no reason to add to the TGA cash hoard at the Fed. This switch in funding preference by the Treasury is just starting and should introduce term premia into long-term rates until the Fed figures out its YCC plans.
George is a twenty years fixed income veteran. Over that time he has been an active participant on the research and investment side covering rates, structured products and credit. He worked both on the buy-side and sell-side. He can be reached here.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)