Navigating the Fiscal Tightrope: Reverse Repos & Bonds
In the realm of fiscal policy, the U.S. Treasury’s recent strategies have come under scrutiny, with financial analysts closely examining their approach to managing deficits and interest rates. This article delves into the intricacies of the Treasury’s bond auctions, emphasizing its reliance on short-term Treasury Bill (T-Bill) issuance and the consequential draining of funds from the Reverse Repo Facility (RRF).
Bond Auctions: A Temporary Fix?
The Treasury consistently uses bond auctions to fund the US deficit and has received some criticism for issuing so many short term bonds (maturities less than 1 year). When 30 year rates were at 1.35%, it would have been an ideal time to lock in more funding at higher rates. However tempting this theory is, it wouldn’t have worked cleanly:
- The amount of issuance of long term bonds required to make an impact on average Treasury financing rates would have been huge
- It would have required financial actors (e.g. banks) to absorb a huge amount of long term fixed rate securities.
This article delves into the shorter end of the curve and its dynamics!
Interest Rates and the Yield Curve
The dynamics of interest rates play a pivotal role in shaping the Treasury’s strategy. The US government is currently running a huge deficit and this has to be funded with bonds. This dynamic is exemplified by the Treasury issuing a huge amount of short term bills.
As I alluded to earlier using long term bonds isn’t so simple. Someone (e.g. banks) have to buy them, then manage the interest rate risk on them. As shown by the SVB, First Republic and Signature banks; even the ‘tech forward’ banks weren’t very good at managing the risk on it. The idiosyncrasies of this is outside the scope of this article, however.
Understanding Repo and Reverse Repo Facilities in Financial Markets
The Repo (Repurchase Agreement) Facility and Reverse Repo Facility are vital tools in the financial markets, enabling short-term borrowing and lending transactions between financial institutions. These facilities play a crucial role in managing liquidity, influencing interest rates, and supporting the overall stability of the financial system.
The Repo Facility is run by the Federal Reserve’s FOMC, and allows market participants to obtain short-term funding by selling securities with an agreement to repurchase them at a later date. In essence, it serves as a collateralized loan, with government securities, corporate bonds, or other high-quality assets acting as collateral. The party selling the securities agrees to repurchase them at an agreed-upon price, which includes interest, providing the lender with a return on their investment.
On the other hand, the Reverse Repo Facility allows financial institutions to lend excess funds to central banks or other counterparties by temporarily acquiring securities. This serves as a crucial tool for central banks to absorb excess liquidity from the financial system. The party engaging in the reverse repo transaction lends funds and receives securities as collateral, earning interest on the transaction.
These facilities exist to address short-term liquidity needs, facilitate the smooth functioning of financial markets, and implement monetary policy. The repo market, in particular, is a critical component of the financial system, providing a mechanism for financial institutions to meet their short-term funding requirements. Understanding these facilities is essential for participants in financial markets, as they directly impact interest rates, market stability, and overall economic health.
I bolded the point on absorbing excess liquidity because that is out current state of the market. Banks have more cash than they need on a day-to-day basis. This came about largely after the massive pandemic cash stimulus. To oversimplifiy there are cases where banks have excess cash, don’t feel comfortable about lending it out, and park it at the RRF for 1 day. The banking market is gradually having less ‘excess’ cash but as you can see from the chart, having zero excess cash in the system isn’t necessarily a problem. Before the pandemic it was a rarer occurrence.
Short-Term T-Bill Auctions: A Strategic Pivot
Coming back to the bond market, the Treasury’s pivot towards short-term T-Bill auctions is a response to the evolving interest rate landscape. There are two key reasons behind this shift: firstly, to avoid being locked into long-term high-interest rates that could worsen the deficit and interest expenses, and secondly, to entice capital back from the Reverse Repo market by offering yields slightly higher than 5.3%. This tactical move reflects the Treasury’s attempt to navigate a challenging financial terrain.
If the banks didn’t have this ability to earn a return on the cash it would incentivize them to search for return elsewhere (e.g. give out loans that may fail).
The Treasury’s plan seems to be progressing well. In recent months, the Treasury has successfully drained approximately $1.5 trillion from the Reverse Repo Facility. The Q4 refunding plan further solidifies the Treasury’s commitment to this strategy, indicating a willingness to stay well above the traditional ratio of T-Bills to Bonds.
An Unconventional Ratio: T-Bills vs. Bonds
Examining the composition of recent Treasury auctions, we see a departure from the norm. The Treasury has effectively inverted the standard ratio, auctioning around 65% T-Bills and only 35% Bonds over the past year. This unconventional approach suggests a deliberate effort to adapt to the evolving economic landscape.
Implications of Rapid Reverse Repo Facility Draining
Using the estimated $1.5 trillion of upcoming auctions between now and the end of the first quarter of 2024, the Reverse Repo Facility will soon be drained. If the Treasury maintains the current pace of auctions, the RRF could be depleted as early as January. This potential scenario raises questions about the Treasury’s contingency plans and the stability of financial markets.
Future Challenges: Falling Rates and Increasing Deficits
There is a critical question regarding the Treasury’s future moves: where will they turn when interest rates start to fall? With the government running annual federal deficits of $2 trillion, the Treasury finds itself in a challenging position. The article underscores that this situation is occurring before the potential onset of a recession, which could further exacerbate deficits.
What’s Next?
When the reverse repo facilitaty ‘runs dry’, meaning there is no demand for its use, it is likely going to be hyped by the financial press. Here I want to enumerate some options:
Banks have less cash
Financial conditions get tighter as banks are more discerning about who they lend to.
Banks are parking their money elsewhere
The RRF isn’t the only option for parking money, but it represents a good option. The 30 year bond yield topped at arount 5% and has been dropping. There is a small chance banks are opting for long term bonds, or other short term financing options like IORB.
Summary
In terms of what’s next there are two forces working against each other. The fiscal deficit is creating money that stimulates the economy, some of this can end up in banks assets and then into the RRF.
The fighting dynamic is the impact on bond yields as more are auctioned to fund the deficit. As the yields increase it causes financial conditions to tighten (i.e. harder to get loans; and loans make less sense to borrowers).
The decline in RRF usage means, in my opinion, that the effects of the financial stimulus are starting to drop off (e.g. stimulus checks are almost done across the US though still exist in a couple states), and we see less excess cash floating around. That said banks still seem well-capitalized (see below). It’s likely to be a grinding out of these two dynamics as congress battles whether to continue running a deficit or reign it in (reducing the supply of bonds thereby lowering rates), or they continue running the deficit (increasing the supply of bonds maintaining upwards pressure on rates).
