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Category: Notes

The Treasury is Dumping $800 Billion Out of the TGA, and it’s NBD

The Treasury stated in its refunding statement that it will reduce the Treasury General Account (“TGA”) to $800 billion by quarter-end, an $800b decline from where it is today. The TGA is the Treasury’s checking account at the Fed (like commercial banks, the Treasury has a Fed account and can hold central bank reserves). When the TGA is run down, that liquidity will enter the financial system as reserve assets for commercial banks (balanced by deposit liabilities to non-banks), and deposit assets for non-banks. This post briefly introduces the TGA, explains the mechanics of the upcoming decline, and discusses how the huge influx of liquidity could affect markets.

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The Debt Jubilee is Already Here

Debt jubilee is debt forgiveness, and it’s already happening at a staggering rate for public sector debt. Sovereign debt is fundamentally different from private debt in that the sovereign makes the rules and never has to repay its debt. When the Fed purchases a Treasury, and then continues to roll over that Treasury forever, then that debt is effectively cancelled. That is why public sector debt is not deflationary, nor a drag on growth. This post walks through the mechanics of our modern day debt jubilee, and how it can help deleverage private sector debt.

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The U.S. Treasury is Steepening the Curve in a Big Way

The U.S. Treasury’s most recent quarterly refunding statement is out and it looks like they are steepening curve. Just as the Fed can influence the shape of the yield curve by adjusting the maturity profile of its asset purchases (see Maturity Extension Program aka Operation Twist where the Fed flattened the yield curve by selling short-dated Treasuries and buying longer dated Treasuries), the Treasury can influence the shape of the yield curve by deciding on where to issue on the curve. In this post we discuss the how supply and demand dynamics can affect the shape of the Treasury curve, and why the Treasury curve can continue to steepen significantly.

The 2s10s curve is still historically flat

Basic Supply and Demand Factors Affect Yields

Putting aside fundamentals, such as expectations for the future path of Fed policy or inflation, Treasury yields are affected by basic supply and demand dynamics. If Treasury issues a lot of debt, then yields will go higher. The Treasury market is the deepest market in the world, but a large enough surge in debt issuance will still need to be digested. Investors may not immediately have enough cash on hand to absorb the issuance, and yields may need to rise to attract investors from other corners of the market.

This dynamic can easily be seen in $300 billion surge in Treasury bill issuance in early 2018, which pushed bill yields as a spread to OIS to widen 20 basis points in a matter of weeks (the Overnight Index Swap is an estimate for the expected path of Fed policy and used here to separate higher bill yields due to expectations for a Fed hike). The Treasury bill market is the most liquid part of the Treasury curve with a very large investor base, including the multi-trillion money market fund complex. However, $300 billion is also a large chunk of debt. Bill yields had to increase to attract money away other short-term investment products like commercial paper and bank CDs.

How the U.S. Treasury is Steepening the Yield Curve

Treasury is changing the composition of their issuance: fewer short-term debt and more long-term debt

The Treasury seeks to issue debt at a rate that is “regular and predictable,” and at the least expected cost overtime to the tax payer. In practice that means that they set a predictable auction schedule for coupon securities and meet any unforeseen cash needs by issuing Treasury bills (coupons are Treasuries that mature in 2 to 30 years and pay semi-annual coupons, as opposed to Treasury bills which are issued on a discount basis and mature within a year). For example, the unexpected surge in Covid related government spending in 2020 was first met by significant bill issuance in April and then larger coupon issuance sizes in the following months.

The Treasury projects that for the current quarter it will be reducing the amount of bills outstanding by $400 billion and increasing the amount of coupons outstanding by $700 billion (Note that the Fed will also buy around $240b this quarter). The Treasury’s projections do not take into account any stimulus legislation, so the projections may change if further fiscal stimulus is announced. But as it stands the Treasury is effectively steepening the curve. Decreasing the supply of Bills lowers short-term rates, while increasing the supply of longer dated coupons raises longer-term rates.

Yields Are Set to Move Higher (Until the Fed Steps in)

The Treasury is prudently managing their debt by taking advantage of historically low long-term rates, and a Fed that is actively buying. Since longer term rates are low, it makes sense to issue more longer dated debt. The Treasury behaved the same way the last time QE was in full force. But the level of issuance this time is unprecedented, and is currently projected to be $2.5 trillion in coupons this year and the next. Back in early 2020 a $1 trillion in net issuance would be a large number, but now the Treasury is consistently issuing over $2 trillion. Even with the Fed’s buying $80 billion a month this still a sizable amount over a short period of time.

Office of Debt Management Projects $2+ trillion in net coupon issuance

The Fed would never allow yields to go too high and it has absolute control over the yield curve. Note that central banks around the world have been able to effectively engage in “yield curve control” and pin certain parts of their yield curve (See Japan pinning their 10-year and Australia pinning their 3-year). But with U.S. 10-year real yields bouncing around historic lows of -1%, it seems that there is still room for the market to move yields higher before the Fed would step in. This is especially true if higher yields are accompanied with a narrative of higher economic growth. With short dated rates anchored by both the Fed and the large level of cash in the system, higher longer dated yields imply that the curve should continue to steepen.

Dollar Depreciation is the Plan

The U.S. dollar index has steadily declined over the past few months. This has generated much market commentary, with many noting the soaring gold prices (and bitcoin) as suggesting that the death of the dollar is imminent. But depreciating the dollar in a global recession is just standard, and predictable, macro policy. In this post I’ll walk through the rationale for depreciating the dollar, how that is being accomplished, and whether that means the dollar will lose its reserve currency status.

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Sketching the Passive Investment Target Date Fund Whale

A number of prominent market commentators (see Mike Green at Logica Funds or Vincent Deluard of StoneX) have noticed that the growing passive investment target date fund complex has fundamentally changed how the financial markets work. While active investors invest according to a valuation metric, passive investors simply allocate capital without any reference to valuations. In recent years passive investors have steadily increased in influence and appear to be on an unstoppable march towards dominance.

A market dominated by active investors is mean reverting. When the market is too “cheap” then the active investors buy, and when it is too “expensive” then the active investors sell. These active investors – such as traditional long/short asset managers or any disciple of Benjamin Graham – will have different views of what valuations are, but they will agree that valuations matter.

On the other hand, passive investors don’t care about valuations. Their instructions are to invest the money given to them, regardless of price. For example, a typical 401k plan will receive a contribution at each pay period and invest it in the market according to a preset allocations, such as 50% in equities and 50% in bonds. That investment occurs regardless of any valuation metric. A market dominated by passive investors thus trends higher.

Passive investment vehicles have steadily grown in recent years as corporations set-up their employees with target date retirement funds. This has been providing a steady bid in the market, likely contributing to the slow grind upwards seen in major U.S. equity indices. But how influential are those funds?

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Central Bank Digital Currency: Is it the Future?

This week Fed Chair Powell was on a panel hosted by the IMF that discussed digital currencies in the context of cross-border payments. Powell noted that the Fed was looking into this, but didn’t offer much else. This is probably because CBDCs don’t really have any applications in the U.S. In this post I’ll talk about what problems CBDCs could solve, how it could be helpful for other jurisdictions, and why it doesn’t seem to make sense in the U.S.

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Can Banks Spend Their Reserves?

Bank reserves can never leave the balance sheet of the Fed, but that does not limit how they can be spent. Reserves are a form of money and can be spent on anything. However, banks transact with other banks in a different way than how banks transacts with non-banks. This is due to our two-tiered monetary system, where not everyone is eligible to hold reserves. For the cryptocurrency fans: this is the equivalent of a bitcoin holder able to pay another bitcoin address, but unable to send bitcoin to someone with only a Ethereum address. In this note I sketch out a few illustrations that should be helpful in understanding how this works in a bank-to-bank and bank-to-non-bank scenario.

Note: Although banks can spend reserves on anything, bank are heavily regulated in what they can buy. They cannot go out and load up on equities and high yield or other risky assets without violating risk and regulatory limits. Regulation and profitability, not reserves, is what constrains a bank’s balance sheet.

Bank to Bank Transactions

In this example a bank will purchase an asset – be it a Treasury, office building, car etc. from another bank. The transaction is essentially an asset swap, where Bank A swaps $100 in reserves for an $100 asset that Bank B holds. The aggregate balance sheet of the banking system does not change.

Bank to Non-Bank Transaction

In this example Bank A will purchase an asset from a non-bank, who banks with Bank B. Note that this results in the creation of bank deposits. The Non-Bank essentially converts his asset into bank deposits through the sale. Bank deposits are created when a bank creates a loan asset or buys something from a non-bank.  Whereas the aggregate level of reserves in the banking system is unchanged, the aggregate balance sheet size of the banking sector is $100 larger. The spending of reserves by any individual bank does not change the aggregate level of reserves in the banking sector, but it does shift the distribution.

In practice, banks must hold a certain level of reserves to meet regulatory liquidity thresholds. For large banks, this is usually to meet the Liquidity Coverage Ratio. The LCR mandates banks to hold a level of high quality liquid assets like reserves, Treasuries, or reverse repo backed by Treasuries in proportion to their expected 30 day outflows. Banks that spend their reserve levels will thus only buy other HQLA assets like Treasuries or Treasury reverse repo. For example, in late 2018 JPM decided to invest a large chunk of its reserves into reverse repo. This was a time when repo rates (proxied by the Secured Overnight Funding Rate) rose comfortably above the Interest on Reserves paid by the Fed on reserves. 

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