US Policy Net Liquidity Challenges And Market Implications

With the dust now settled post weeks of massive Fed liquidity injections, I explore the concepts of the Fed’s directive to maintain “market function” and what that means for policy and markets ahead. Clearly the rate vol in March was amplified by broader cross currents impacting all markets into the COVID-19 lockdowns. However, the issues that have been plaguing the bond market actually started in 2019.

Net, the Fed addressing repo demands and excess reserves in 2019 was largely about US finance needs. Similarly, what has happened post the COVID-19 supply ramp, the Fed has provided Treasury capacity to issue more to public markets, where the Fed can always buy more if private interest were to ever wane.

Let’s be clear, the Fed is not going to stop purchasing Treasuries any time soon. However, the peak benefit of the Fed’s liquidity is behind us in my view, especially as supply shifts towards the longer-end.

2019 Was A Test Run For Treasury Market Liquidity Via The Fed’s Balance-Sheet

It is worth reminding that Treasury supply was already in an upswing before the latest issuance spikes due to COVID-19. This was thanks to the Fed’s former quantitative tightening program (which placed Treasuries back into the market) and simultaneously the increasing deficits to fund the Trump tax cuts.

In addition, all this extra supply was encumbering the primary dealer (PD) network in 2019 and that eventually led to issues in the repo market in mid-September 2019. The Fed responded with the introduction of repo operations (an asset on the Fed’s balance-sheet) that provides the PDs liquidity in dealing with all this paper. As seen in Chart 1, in order to increase excess reserves even further, the Fed bought T-bills for the first time in over a decade via the Treasury Reserve Management (TRM) program.

2019 in many ways set the wheels in motion for a permanent enlargement of the Fed’s balance sheet and brought the Fed closer into the Treasury’s orbit (to which the events of 2020 have strengthened that gravitational pull). The flare-ups in short-term rates exposed that higher government borrowing needs were impacting money markets as dealers finance most of their positions in repo. It also exposed the connection between the Treasury’s general account (TGA is a liability on the Fed’s balance sheet) and excess reserves. Post the debt ceiling conclusion the Treasury was ramping up T-bill supply to fund the TGA (Treasury’s checking account), and this was resulting in a draining of excess reserves. But at the same time, the added T-bill supply was putting pressure on short-term rates into 4Q19. The Fed repo and TRM program bought markets time but never really fully resolved the supply frictions in the system.

The Easy Part Of The Supply Ramp & Fed QE Are Behind Us

2020 took all of these market dynamics to a whole other level when the Fed stopped buying T-bills (as seen in Chart 1, above) and began a campaign to restore proper Treasury market functioning during the volatile days in March. The Fed was, during some weeks, buying as much paper as it did during multiple months in the earlier QE programs. Since then they have tapered their buying to a fraction of the peak activity. Meanwhile, we are seeing signs of repo usage at the Fed start to increase again as the US government is now issuing larger coupon securities in addition to maintaining a large stock of T-bills.

It’s important to emphasize that the Fed did not purchase any new T-bills in their SOMA (System Open Market Account is where the Fed holds its s/t and l/t bonds etc)  post the COVID-19 market vol (the increase in the chart was the prior T-bill purchases that stopped once the Fed switched strategies). Instead, as seen in Chart 2, the Fed in essence retired a lot of longer-dated Treasuries. Meanwhile the Treasury was initially raising new funds via T-bills (which again their proceeds ended back at the TGA).

We understand the semantics and that ultimately the Fed basically bought the same number of Treasuries as the government was issuing. It just didn’t purchase where the concentration of issuance took place, i.e. mostly via T-bills. Now comes the challenging part as longer-dated supply is getting ramped up and coming to market with larger auction sizes (some of which are remaining with dealers).

Higher Rates – The Achilles’ Heel For Broader Markets And A Precursor To YCC

Let’s be clear, the Fed is not going to stop purchasing Treasuries any time soon. However, the peak benefit of the Fed’s liquidity is behind us in my view. Issuance will remain large versus what the Fed is buying and that could trigger a boomerang effect of driving PDs to once again use repo as a bridge loan as they did during 4Q19. The consequences of all this could be that some funding pressures arise (but with the Fed Funds rate now pinned that is less of an issue), yet the real vol. will shift out the curve as all these longer-dated bonds come to market over the coming months to fund the various fiscal plans. This could result in moments of higher rates and steeper curves, which initially risk markets may champion.

But eventually the bond market will compete with other risk assets as an investment alternative. In the end, this will force the Fed to do YCC, but that transition to such policy could lead to intermittent vol. as it would indicate that the liquidity machine needs to be constantly on in order to keep rates contained.

George is a twenty years fixed income markets veteran. Over that time he has covered 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.)