Liquidity risk materializes? US Treasury increases issuance of short-term bonds, funds withdraw from the Fed's reverse repurchase agreement tool.

With the US Treasury increasing the issuance of short-term Treasuries to meet financing needs, the market liquidity is showing new trends. A large amount of funds is flowing out of the Fed's overnight reverse repurchase agreement (RRP) tool and into the more attractive Treasury market. This change has raised concerns among market participants that if the cash "buffer pool" is depleted, the tight funding conditions in the money markets seen in 2019 may be repeated. Data shows that the use of RRP has significantly decreased. In December 2022, the volume of this tool hit a historical record of $2.6 trillion, but as of this Thursday, only 14 institutions are using it with a total amount of $28.82 billion, the lowest since April 2021; the five-day average also dropped to $519 billion. In contrast, in July, the US Treasury issued a net addition of $212 billion in Treasuries, with about two-thirds being taken up by money market funds. Teresa Ho, head of short-term strategies at J.P. Morgan, pointed out that these funds are the main users of RRP, and they are now reallocating their funds to higher-yielding short-term Treasuries. Earlier this month, the Treasury set a record by simultaneously issuing $100 billion of 4-week notes and $85 billion of 6-week notes, with the latter offering a yield 5 basis points higher than overnight reverse repo. Citi strategists predict that the balance of RRP will approach zero by the end of this month. Once RRP funds are exhausted, the next potential source of funds will be the $3.32 trillion in reserves that banks hold at the Fed. However, the market cannot afford a significant decrease in reserves. In 2019, a sharp drop in reserve balances caused turmoil in the repo market, with the Secured Overnight Financing Rate (SOFR) soaring, forcing the Fed to intervene. Citi predicts that bank reserves will drop to $2.8 trillion by the end of this year, while Fed Governor Waller believes they may further decrease to $2.7 trillion, but there is still no clear consensus on what constitutes a "comfortable" level. Angelo Manolatos, macro strategist at Credit Suisse, warned that the next six weeks will be a critical test for the US dollar repo market, especially during the middle of September when corporations pay their taxes, which could lead to a significant increase in liquidity pressure with over $260 billion in net Treasury supply added. He noted that at special points like quarter ends, overnight lending rates have already shown fluctuations, and if funding costs continue to rise sharply in September, structural problems in the market may arise. Alejandra Vazquez Plata, rate researcher at Citi, also stated that weak demand at recent 1-year Treasury auctions is an early sign of decreased liquidity. If the Treasury continues to issue a large volume of debt, investor interest may decline, leading to a need to increase yields to attract buyers, thus pushing up the government's short-term financing costs. The Treasury responded by saying they will "closely monitor market conditions and adjust issuance plans flexibly," and plan to further increase Treasury auction sizes in October. However, some believe that there will not be severe shocks in the market in the short term. Ho from J.P. Morgan believes that the assets of money market funds can still expand, thus being able to absorb more short-term Treasuries. Data shows that as of August 7, $61.4 billion has flowed into Treasury-related ETFs in the third quarter of this year, almost double the amount compared to the same period last year, indicating that overall demand is still strong. Steven Zeng, strategist at Deutsche Bank, warned that if the financing market continues to be under pressure, it may affect the US stock and corporate bond markets. With the S&P 500 index still at high levels, investors need to be particularly vigilant of this risk.