Treasury markets are losing their shock absorber

Fed officials have viewed lower use of the reverse repo facility as a positive sign that excess cash is making its way to more attractive opportunities in the market. (Photo: Ting Shen for WSJ)
Fed officials have viewed lower use of the reverse repo facility as a positive sign that excess cash is making its way to more attractive opportunities in the market. (Photo: Ting Shen for WSJ)

Summary

Declining balances in reverse repo, where funds stow their cash overnight in exchange for interest, presage a trying period in the most central market.

Participation is dwindling in a Federal Reserve program that has helped the U.S. government limit its borrowing costs, a development that many investors say presages higher interest rates and larger swings in the $26 trillion Treasury market.

The overnight reverse repurchase facility, known on Wall Street as reverse repo, enables large financial firms such as money-market funds to briefly swap extra cash for high-quality securities on the central bank’s balance sheet and pocket some interest. The Fed program has been used heavily in recent years, at one point hitting $2.5 trillion of daily balances, but that number has shrunk steadily and recently fell below $500 billion.

Many analysts and portfolio managers expect use of the program to continue to decline, which they say is likely to constrain the functioning of an important shock absorber in the market for U.S. Treasury securities. The government is facing higher interest costs as it attempts to fund a growing deficit, and observers say lower balances in the program could mean higher volatility and a fresh rise in interest rates in the market that underpins the global financial system.

“It is undoubtedly easier for the market to absorb bill supply if you have a large amount of cash in an overnight facility waiting to be deployed," said Michael de Pass, global head of rates trading at Citadel Securities.

Though obscure, reverse repo has long been at the center of the operation of the financial system and the U.S. economy. A committee that advises the Treasury suggested last fall that the heap of money-market fund cash sitting at the Fed could finance a flood of short-term bill issuance—an unusual shift that in recent months has enabled the government to keep long-term interest rates relatively low despite the quickening drumbeat of U.S. debt issuance.

Sales of Treasury bills, which mature in a year or less, surged during the pandemic and then again in 2023. There is now nearly $6 trillion of T-bills in the market, up from less than $2 trillion at the end of 2017.

That might seem like a technical development, but it is anything but for players in the global bond market. All this short-term debt will need to be refinanced at higher rates at the same time the Fed has been lifting benchmark interest rates. While selling bills allows the government to raise cash quickly, the bills soon come due, forcing difficult decisions on how to raise funds again.

Many bond investors say the Treasury Department will eventually have to come to grips with how it plans to pay its bondholders over the long haul, as interest payments become one of the largest expenses in the federal budget.

For now, the U.S. has been able to keep investors happy. In November, the Treasury Department maneuvered around buyers’ concerns over the limits of investor demand for long-dated Treasurys by selling an unusually large amount of bills, allaying market fears that demand for U.S. debt was waning.

Fed officials have viewed lower use of the reverse repo facility as a positive sign that excess cash is making its way to more attractive opportunities in the market. Once reverse repo has mostly drained, the Fed expects the banking system to begin losing reserves. A bank uses reserves, a form of electronic cash, to manage transactions between itself, its customers, other banks and the central bank.

While the central bank has been trying to tighten banking conditions to help cool the economy and therefore inflation, money-market funds have pulled cash out of reverse repo and back into the economy, counteracting that tightening. Officials are eager to avoid reserves becoming substantially scarcer, which would increase the risk of snafus in the multitrillion-dollar cash markets that can cascade into the broader financial system. Lehman Brothers’ collapse in 2008, the Fed’s attempt at quantitative tightening in 2019 and the onset of Covid-19 are all top of mind. The Fed is expected to slow the pace of quantitative tightening this year so it can watch for potential strains.

Not everyone thinks a smaller reverse repo cash pile is much of an issue.

“Bills can be a plug for the government, as financing needs move around based on tax collections and spending needs," said Jason Granet, chief investment officer at BNY Mellon. “Even if you get a recession that demands more government spending, that’s the type of environment people usually want more Treasurys."

Much of the reverse-repo flows are also a function of the record cash investors have plowed into money-market funds, which now hold more than $6 trillion in assets. Limited to highly rated short-term investments such as Treasury bills and repurchase transactions, money funds parked a chunk of those inflows at the Fed. They now earn a 5.3% annualized rate overnight with the safest counterparty around.

Blake Gwinn, RBC Capital Markets’ head of U.S. rates strategy, said he expects roughly $100 billion to $200 billion to remain in the Fed’s reverse repo facility over time. Should the Fed cut rates, it will immediately begin paying less to reverse repo investors. Having a source of overnight cash is another plus.

“The Treasury takes a very long time horizon—they’re thinking about how much it’ll cost to fund the government over a 10- to 30-year period," said Gwinn. “I don’t think they’re very concerned about losing demand for bills."

Write to Eric Wallerstein at eric.wallerstein@wsj.com

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