The $1.7t in the RRP can help finance the upcoming deluge of coupon Treasuries, but it won’t be easy. Treasury bills will easily be funded, but the bulk of the upcoming supply from net issuance and QT is likely coupons. There are only two ways the RRP can finance coupon Treasuries: 1) funding repo loans to leveraged Treasury investors or 2) funding money fund redemptions to cash Treasury investors. Both mechanisms are subject to frictions that suggest a messy process. Leveraged investors may encounter dealer balance sheet constraints, and cash investors may need a much steeper curve. In this post we describe the two mechanisms and highlight the potential for an “air pocket” in the Treasury market where the marginal buyer is many, many ticks away.
The pipes through which RRP money flows to leveraged Treasury investors may not be wide enough to finance upcoming supply. Leveraged investors are “fast money” investors who can quickly borrow large sums of money to take advantage of market dislocations. Money flows to them through dealer balance sheets, which are the main “pipes” of the financial system. Cash investors lend to dealers, who relend to leveraged investors, who then use the cash to purchase Treasuries. This transaction “expands” a dealer’s balance sheet because it adds both a repo asset (loan to hedge fund) and a repo liability (loan from cash investor). In theory, money market funds (“MMFs”) can shift their investments out of the RRP and into repo loans that end up funding Treasury purchases. But in practice, balance sheet constraints will limit this flow.
The pipes today are narrower than they were pre-GFC even as the size of the Treasury market has exploded higher. Dealers were borrowing $3t in repo on the eve of the GFC, but only $1.5t at the end of 2021. The decline is in part due to regulatory changes that penalize large balance sheets. At the same time, the supply of Treasuries has increased from $5t to $23t and counting. This suggests that the leveraged community will ultimately run out of financing even if they do want to buy Treasuries. Note the Fed’s new Standing Repo Facility does not help since the constraint is not cash available, but balance sheet.
A new financial product called Sponsored FICC is widening the pipes, but it won’t be enough. Sponsored FICC allows a dealer’s clients to engage in nettable repo, which conserves the balance sheet space of dealers. A dealer who borrows and lends $100 in nettable repo can net the two legs of the transaction so its balance sheet size is little changed. Sponsored FICC is growing in popularity but does not yet appear to have a high level of participation among leveraged investors.
Money in the RRP can also make its way into the Treasury market indirectly via MMF investor redemptions. In that case, an investor withdraws cash from a MMF and uses it to purchase Treasuries. The MMF in turn meets that redemption by withdrawing money from the RRP. The relative importance of this mechanism is hard to gauge because a wide range of investors hold their cash in MMFs. The largest investors type in MMFs are households, which is a category that includes a diverse set of participants from retail to hedge funds. However, there are macro forces that are working to disincentivize MMF withdraws.
The Fed’s expected rapid hike cycle and high inflation suggest investors have less reason to move out of MMFs and into longer dated Treasuries. MMF returns will rapidly rise if the Fed follows market expectations and hikes to over 2% by year-end. The relatively flat curve means investors would have limited yield pickup by moving out the curve. In addition, rising inflation is increasing the cash needs of investors as everything costs more. A meaningful investor shift out of the front end and into other segments of the curve may require a materially steeper curve.
With a large RRP more bark than bite, the Treasury market may come under strain from the massive upcoming supply. There is reason to think the world’s most liquid market is actually fragile. Over the past 20 years, Treasuries outstanding rose 7 fold while daily cash volumes only rose from $370b to $620b. This suggests a market with steadily deteriorating liquidity, which means any potential tremors will be magnified. Rising rate vol indicates that liquidity is evaporating, and the events of March 2020 have already shown that the cash Treasury market can run out money. Trillions more of Treasuries will soon flow into the market to test its resilience.