Money Markets Are Giving Fed Room to Keep Shedding Treasuries

(Bloomberg) — Money markets are giving the Federal Reserve a green light to continue shedding Treasury securities from the massive pile accumulated as part of its pandemic response.

Most Read from Bloomberg

By not rolling over all of its maturing holdings of US government debt, the Fed is forcing the Treasury to borrow more from the investing public. The risk is that the increased borrowing will drain reserves from the banking system to low levels that have caused problems in the past.

So far, that’s not happening. A surge in the quantity of Treasury bills being sold since US lawmakers agreed to suspend the debt limit in early June appears to be finding a home mainly with investors who have vast resources elsewhere.

“We’re going to have a reserve adequacy debate at some point, but not in the immediate future,” Wrightson ICAP economist Lou Crandall wrote in a note to clients.

Money-market mutual funds that normally are big buyers of Treasury bills have been parking cash in the Fed’s reverse repurchase agreement facility due to bill scarcity while the debt limit was in effect. A slump in usage of that daily operation suggests that money funds are scooping up most of the increased bill supply, limiting the impact on bank reserves. The total remains above $3 trillion. Wall Street strategists estimate — with low conviction — that the banking system needs at least $2.5 trillion to function smoothly.

Since late May, the so-called RRP has shrunk by an amount roughly equal to about 67% of the $345 billion increase in bill supply, according to Wrightson. It fell below $2 trillion for the first time in a year.

The Fed’s balance sheet has shrunk by about $500 billion from its March 2022 peak to $8.4 trillion. The central bank is closely monitoring the effect of increased Treasury borrowing on bank reserves, Fed Chair Jerome Powell said this month.

In keeping a close eye on reserve levels, the Fed is trying to avoid a repeat of an unintended consequence of so-called quantitative tightening from 2017-2019. During that time, a drop in reserves caused overnight financing rates to soar, forcing policy makers to respond with stabilizing measures.

A key risk is that money-market funds appetite for Treasury bills is waning. Shifting assets from the Fed’s RRP to bills affords higher returns, but also exposes funds to the risk of additional interest-rate increases by the central bank, which policy makers have signaled are likely.

Morgan Stanley strategist Efrain Tejeda predicts reserves will fall by about $400 billion to $2.8 trillion by the end of the third quarter, with RRP balances dwindling to about $1.7 trillion.

Bill supply is projected to increase by at least another $1 trillion this year. The final $300 billion could create problems, TD Securities’ head of US rates strategy Gennadiy Goldberg told attendees at Crane’s Money Fund Symposium last week.

“What’s bothering us is how much of the cash potentially leaves the RRP and whether there’s reserve scarcity,” Goldberg said during a panel.