Market Wrong to Fear Equity Selloff on TGA Increase

Summary

• The US Treasury plans to increase the Treasury General Account (TGA) by $500bn over the next four weeks, which would cause large money market volatility and is therefore likely to be revised down.
• But even a gradual increase in the TGA to $600bn by end-Q3 2023 would likely lower reserves to levels inconsistent with the Federal Reserve (Fed)’s abundant reserves operating framework. This suggests an end to quantitative tightening (QT) before end-Q3.
• The correlation between equities and reserves has been positive as well as negative, depending on the underlying drivers of reserves changes and equity performance.

Market Implications

• Bullish equities.

TGA Build-Up Plans Are Unrealistic

There is a view in the market that a fast rebuild of the TGA will lead to a sharp decrease in reserves and an SPX crash. I disagree with this on many levels.

First, current Treasury plans to increase the size of the TGA by $500bn over the next four weeks are grossly unrealistic.

Over the next four months, I expect Fed assets to shrink by about $100bn per month (Chart 1). This is based on about a $70bn reduction in the securities portfolio, the pace of the past six months, and a $30bn reduction in lending to banks (i.e., continued banking system stabilization).

Against this backdrop, on 1 May the Treasury announced that it will raise the TGA to $550bn at end-June and to $600bn by end-September. Since the TGA is currently $50bn, the Treasury proposes to increase the TGA by $500bn over the next four weeks and by an additional $50bn over the following three months. The impact on reverse repurchase agreements (RRPs) and reserves would be the equivalent of five months of QT and loan repayments in one month!

The combination of QT, loan repayments, and TGA increases would lower RRP and reserves by $600bn in June. This would be an unprecedented decline that would cause a liquidity squeeze in money markets, and a surge in interest rates, including a move of the Federal Funds Rate (FFR) outside its target range.

It therefore seems unlikely that the Treasury will proceed with its original plans. Instead, it is likely to rebuild the TGA gradually.

That said, even if it is gradual, a $550bn increase in the TGA will lower reserves and is likely to lead to the end of QT.

TGA Build-Up Implies the End of QT

Second, building up the TGA will likely lead to ending QT early to maintain the abundant reserves on which the Fed’s operational framework relies. The increase in the TGA to $600bn by end-September is likely to impact reserves more than the Fed RRP. This is because banks’ loan to deposit ratios are still below pre-pandemic levels and banks are still not passing the FFR increases to their depositors. This suggests that banks are not actively seeking to stabilize their deposit base (Chart 2). As a result, the deposit flight into Money Market Funds (MMF) and MMF use of the Fed RRP are likely to continue.

I therefore assume that about a third of the decline in Fed assets and increase in TGA will be absorbed by the RRP and about two thirds absorbed by reserves (Chart 3). 

This scenario would bring banks’ reserves into scarcity territory. The Fed maintains an operating framework based on abundant reserves. The main driver of reserves demand is banks’ assets. The Fed operates a fat floor, bounded by interest on reserves (IOR) and by the RRP rate, which are currently 5.15% and 5.05%, respectively. 

Relative to banks’ assets, reserves are currently about half a percentage point above the level where, in Q1 2018, the FFR started to move toward the upper bound of the floor, a sign of reserves scarcity (Chart 4). Eventually, in September 2019, the FFR spiked as reserves had become too scarce.

Under my scenario, reserves would fall to $2600bn or 11% of banks assets by end-Q3. This decline would likely be accompanied by a move of the FFR towards the upper part of the RRP-IOR range. Unlike in 2018-19, the Fed would likely be very responsive to such a signal of reserves scarcity and end QT.

This would put a floor under reserves, but at a lower level than currently. This need not be negative for equities. 

Lower Reserves, Higher Equities?

Third, the data shows that the reserves-equities correlation was positive during 2009-14 and 2020-22 while negative during 2015-19 (Chart 5).

This unstable correlation likely reflects the underlying drivers of reserve changes. For instance, the contraction in reserves during 2014-17 was driven by an expansion in the foreign RRP pool, rather than by a contraction in Fed securities holdings. This could explain why equities continued to rise even though reserves were contracting.

Equities continued to rise during QT1 in 2018-19. The selloff of 2018 was, in my view, driven by fears that the US economy was moving back to a higher nominal GDP macro regime, with higher rates and less reliance on quantitative easing (QE). Once the Fed signaled it would cut interest rates, equities perked up remarkably, despite the continued contraction in reserves.

I do not expect that a gradual build up in the TGA and decrease in reserves would lead to a deep and lasting equity selloff. The reasons are the precedent of 2014-19; strong economic growth prospects; a Fed that is behind the curve; and inflation pressures that have yet to become fully apparent. 

Market Consequences

Market fears of a deep equity selloff caused by a sharp increase in the TGA are in my view overblown.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed, the IMF, and the World Bank. She joined Macro Hive soon after its inception.

(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.)