Treasury's Borrowing Strategy Impacting Market Liquidity

Treasury's Borrowing Strategy Impacting Market Liquidity 

How the Treasury plans to fulfill its borrowing needs, balancing short-term bills and long-term coupons, will significantly affect liquidity and the performance of risky assets.

Quantitative tightening is running out of time, and the Federal Reserve is likely to cut interest rates later this year, despite inflation making a comeback.

On Wednesday, the Treasury will reveal its borrowing plans of $243 billion in Q2 and $847 billion in Q3, amounts previously announced on Monday. Q2's figure exceeded expectations, while Q3's was at the higher end. The consensus leans towards meeting the increase with bill issuances rather than coupons.

This differentiation matters.

The Treasury has upped its bill issuances in the past 18 months, allowing money market funds (MMFs) to lend to the government using liquidity stored at the Fed's reverse repo facility (RRP).

Bills now constitute over 20% of total debt, a ratio the Treasury has typically aimed to keep under.

Even if the Treasury doesn't announce a reduction in bill issuances and an increase in coupon issuances this week, it's probable it will happen eventually. Having too many short-term liabilities hampers the Fed's monetary independence (which might already be happening).

However, increasing coupon issuances could negatively impact liquidity. MMFs cannot purchase coupons; it's mainly banks, financial institutions, households, and foreigners. When these entities buy bonds, they need to use reserves.

Banks are the only ones who can create deposits to buy Treasuries, lessening the impact on reserves. But they have been reducing their reserves since the Fed began hiking rates.

Looking at leading indicators, they're likely to continue doing so as they expand commercial lending.

Yet, even before more coupon issuances, the advantage of heavy bill issuances is diminishing.

The domestic RRP is down to $500 billion, and MMFs might stop using it to buy bills even before it reaches zero (preferring to keep cash on hand for withdrawals), causing MMFs' bill purchases to impact reserves and liquidity.

Thus, Treasury borrowing is soon expected to exert more pressure on reserves, increasing the likelihood of Fed policy loosening this year.