personal views of a former fed trader

Quantitative Buybacks

A Treasury buyback program today would be mechanically equivalent to quantitative easing and a tailwind for risk assets. Buybacks funded by bill issuance would move cash out of the RRP and into the broader financial system. The end result would be an increase in cash held by banks and non-banks, both whom may rebalance their portfolios into other assets. In addition, the reappearance of a steady bid for coupon Treasuries would put downward pressure on yields and boost market liquidity. This post shows why buybacks would be mechanically equivalent to QE, reviews two channels QE operates to boost risk assets and suggests a potential shift in the conduct of monetary policy.

Buybacks as QE

When RRP balances are high, Treasury buybacks funded by bills are mechanically equivalent to Fed QE. In addition to reducing market duration, buybacks would also increase the quantity of cash available. This is because the newly issued bills are likely to be purchased by money market funds, who would finance the purchase by withdrawing cash held in the RRP. MMFs have parked $2t in the RRP because the RRP offering rate is more attractive than bill yields, but bill yields would rise with higher bill issuance. The money held in the RRP would ultimately move into the hands of investors through the banking system – increasing the cash holdings of banks and non-banks in a manner identical to QE.

Treasury buybacks financed out of RRP cash is mechanically identical to QE.

Although the Fed did not create new money, the money it had already created becomes more widely distributed. Note that these mechanics would be different if the RRP were empty. In that case the transaction would just be a debt swap.

Rebalancing Channel

A powerful mechanism through which QE impacts risk markets is by encouraging bank and non-bank investors to take on greater duration and credit risk. At a high level, QE changes the composition of liquid assets held by non-bank investors away from Treasuries and towards more bank deposits. These two assets are comparable, but not identical as bank deposits carry bank credit risk and offer limited yield. Some investors are thus incentivized to rebalance by moving along the duration and/or credit risk spectrum. The rebalancing has been reliably risk positive over the past decade.

One dollar of QE creates two dollars of money due to our two tiered monetary system.

QE also increases the cash balances of commercial banks, who then rebalance into a narrow set of high quality liquid assets like Treasuries and Treasury repo. In effect, one dollar of QE creates two dollars of money by increasing reserves (money for banks) and bank deposits (money for non-banks). This arises from our two-tired monetary system, and magnifies the rebalancing impact of QE on assets both banks and non-bank investors buy. The overlapping assets in 2019 were Treasury repo, and post-2020 were cash Treasuries. As reducing bank cash balances via QT predictably led to market weakness in both cases, so increasing cash balances should be supportive.

Market Functioning Channel

QE directly improves Treasury market liquidity by increasing the demand for Treasury securities. Buying a security is equivalent to adding liquidity into the market, as cash is exchanged for a security. In March 2020, market participants had trouble liquidating their Treasuries as a wave of selling overwhelmed buyers. The panic ended only when the Fed stepped in as a dealer of last resort and undertook over a trillion in “market functioning purchases” over the span of just a few weeks.

Source: Bloomberg article by Robert Burgess. Liquidity index measures deviations from spline, MOVE index measures options implied rate vol.

A Treasury buyback program would also mimic QE in its impact on market functioning. On some measures, Treasury market conditions today resemble those of March 2020. The combination of a large primary deficit and QT is creating a wave of selling that the market is having trouble digesting. A sizable buyback program would in effect make the Treasury a dealer of last resort like the Fed. The result is likely comparable to the Fed QE: improved market liquidity and lower yields.

Two Chairs

A Treasury Secretary exercising the power of QE would mark a departure in how monetary policy is conducted. Monetary policy has always been in part determined by actions of the Treasury, who influences the shape of the yield curve by deciding the national debt’s maturity profile. However, a sizable buyback program would be a much more overt foray into monetary policy. It would functionally ease financial conditions at a time when the Fed struggling to contain inflation. The concern over Treasury market fragility is legitimate, but so is the perception of monetary policy independence. The option to goose the stock market at will may also be very tempting.

28 Comments

  1. Rich Vasquez

    One of several ways the Fed can accommodate a world in war and recession.

  2. BrendaN O'Dwyer

    I am really confused on the mechanics of this. My primitive understand is basically the Treasury would buy some off the run securities that don’t have a market and then size up the corresponding closet maturity for what was brought back from the treasury. If I have it right, which I may not, then this is simply a slight change to the duration by months, and kind of a nothing-burger. Please let me know where my understanding is incorrect

    • Koh Phi Phi

      The Treasury would buy off the run LONG term bonds and, in exchange, they would issue on the run SHORT term bills. The point that Joseph makes in this article is that the end result is not just a reduction in duration but furthermore to reduce long-term bond yields (AKA pushing investors down the risk curve) and to increase liquidity: Money Market Funds will reduce their -inert- positions at the RRM to channel them into short term bills.

      • Spencer

        Perverse. The FED should just drive the banks out of the savings business (which doesn’t reduce the size of the payment’s system). The 1966 Interest Rate Adjustment Act is the template.

  3. Elvie

    The whole discussion is based on assumption on buyback fully funded by bill. While for Treasury department, they have debt management principle and also limited by debt limit.. in other words with limited power. Can’t conduct as much as Fed did actually. Besides, if you check latest TBAC discussion material in August, the buyback discussion has multiple variables behind, not as straightforward as your assumption base. Whatever it’s an interesting viewpoint. Let’s see TBAC release this week.

  4. DonT

    Is there positive reflexivity with the Treasury buybacks, where higher stock prices, means higher capital gains taxes, means less need for UST issuance?

  5. Rafael

    But Joseph, this wouldn’t very sustainable as well, given that Treasury bill yields are quite high themselves, and there’s is more debt rolling off in the next 12 months, don’t you agree?

    • Koh Phi Phi

      I agree with this view: funding the purchase of old (low yield) off-the-run bonds with new (higher yield) on-the-run bills is definitely deficitarian for the Treasury.

  6. Paul OBrien

    Great point, thanks. I have long thought that when the government buys back bonds, the distinction between issuing more bills, or expanding bank reserves, was not very important. Indeed, bill issuance is probably superior as it gets the liquid assets in the hands of whomever wants them, rather than force-feeding the banking system.
    The political economy argument is that QE by the Fed is effectively fiscal policy. The Treasury just didn’t protest because it knew the Fed could act swiftly and independently.

  7. Lee Adler

    Thank you Joseph, for your insightful analysis from your perspective of one who has been there and done that. Having been a monetary policy amateur hack since my earliest days of trading in the late sixties, I really appreciate your sharing your expertise.

    Buybacks funded by T-bill issuance would only be bullish for the bond market, not for everything else, I think. From a systemic liquidity standpoint, it would be a wash. Money would come out of the RRPs into T-bills, and that would force a ripple out along the maturity spectrum. The bigger the program, the bigger the wave.

    However, the Treasury seems more likely to use its $650 billion nest egg on deposit at the Fed. That would have bullish impacts in both bonds and stocks until they ran out of money. If they then elect to rebuild to their magic number of 650B, the bullish effects would ultimately be reversed as they suck the money back out of the system.

    If, by then, the various consumer inflation measures have come back to the approximate level of the Fed’s target rates, then the Fed could force more money into the markets by limiting the total size of the RRP daily auctions, theoretically even going so far as to reduce them to zero. That would force $2.2 trillion out of the RRP slush fund and back into the markets. It’s highly unlikely, but regardless of the fact that they’re highly unlikely not to take it to zero, there’s more than enough money there to do plenty of damage to bearish positions over many months.

    Most of that RRP money is MMF cash, so most of it would go into T-bills, but it would also cause a wave across the curve, and more than likely a few ripples into the stock market. Animal spirits are always lurking just below the surface. If the Fed shows any sign of give-up in its inflation flight, the boyz will be back.

    None of these measures would be as bullish as QE, where the Fed deposits cash direct into Primary Dealer accounts as it buys bonds from them, but they’d be bullish enough to get a party going for a year or two,

    Ultimately, it will depend on the Fed’s favorite inflation gauges. If they don’t cooperate, it’s going to get much uglier than anyone can imagine. QT is the most bearish policy action any central bank has ever done. They all did too much QE, and now they’re stuck with a sticky inflation that government anti pandemic helicopter money triggered. The genie is out of the bottle. It’s hard to put it back in.

    The Treasury and the Fed can kick the can again for a year or 2, but they can’t get us out of this mess without a devastating crash somewhere along the line. Maybe now, maybe in a year or two. That’s what technical analysis is for. Timing. Monetary analysis give us the context.

    https://liquiditytrader.com/index.php/2022/10/21/bears-beware-treasury-buybacks-will-turn-the-markets-sooner-not-later/

    • Anon

      Well said, Lee. Couldn’t agree more

  8. Len Ulan

    Thank you Joseph! You have mentioned in podcasts that precise Treasury intervention to improve specific liquidity concerns is a surgical tool to improve functioning without dismantling QT or lowering the Fed Funds Rate. Is your primary concern that any Treasury intervention could become precedent and catalyze de facto QE?

  9. Max G

    The real question is what is the point of this? Is it really “treasury bond market liquidity” and are there other factors/regulations that could be used to improve that liquidity? It seems crazy that the treasury is trying to interfere with monetary policy just to lower the amount of cash in the RRP. Why not just lower the rate on the RRP or lower the maximum amount each counterparty can hold in the RRP?

    More importantly, we should probably ask why is the RRP so big in the first place? Isn’t it because there were excess reserves in the banking system and banks couldn’t hold them because of SLR regulations? At the time, March 2021, the Fed refused to extend SLR calculation accommodations they made during covid. Should we evaluate if not doing so was a smart decision or should be reversed? Why not just adjust those regulations and allow the RRP deposits to come back into the banking system?

    • Koh Phi Phi

      If they simply incentivized the move from the RRP to t-bills by reducing the RRP rate, they would not be lowering the rate of t-bonds. Remember that the Govt prefers a soft landing, so they need to keep the long-end of the curve under control, or else mortgages, corporate debt, etc become too punitive for the economy. So, the buyback program allows them both goals: reduce yields of long-term bonds, and drain the RRP.

  10. Danny

    If MMFs are the main buyer of on the run Tbills does that make them any less liquid thus less valuable than if they were held by the PDs?

  11. Koh Phi Phi

    This is the part I am trying to figure out myself: the buyback program targets off-the-run long-term bonds, which are currently trading at a heavy discount compared to par value – so much so that it more than makes up for the higher yield paid by the newly issued short-term bills. Right now, some off-the-run bonds are trading at 60 cents on the dollar, so for every $60 funded via new t-bills (yielding 4%), the Treasury could buy off up to $100 worth of old bonds (yielding 1%). Effectively, they are seizing the opportunity to pay off their debt while it is cheap, even though they gotta pay a higher yield for it.

    Could it be this simple, or am I misreading the whole thing?

  12. Larry

    Sorry, i am not sure i follow the concept here that RRP is drained.

    The money from new bill goes into buying back old trsy. It’s self-contained operation (in >out, as yield is up so much), why does it involve RRP?

    • Larry

      I mean the proceed for old trsy could easily goes back to MMF and into RRP facility. The point is the that there is no restriction on the money in RRP. it’s there because it’s the best risk-free short term asset choice. The money will move when that perception changes.

  13. Belal

    Thank you again for posting insightful comments on this topic. However, is this not a bandage, not addressing the underlying structural evolution of the market which needs to be corrected?

  14. ConnectingDots

    In your book you said that the Fed changed from targeting reserves to targeting rates directly by paying on reserves. Couldn’t the Fed accomplish the same thing by only paying on excess reserves? The required reserves are, well, required, so why pay interest on them? By only paying on excess reserves the Fed would still control ST rates but with a small bill to pay.
    Or am I off the reservation with my logic?

    • Spencer

      The FED never targeted reserves. If it did, we wouldn’t have high inflation.

  15. Anonymous

    先生您好,想请教一下各国货币对的影响关键性因子是什么。

  16. mutang

    Such a move would be foolish and would have a complete conflict of interest from the taxpayer’s standpoint. Instead of retaining longer-term debt at relatively low interest rates, the UST would refinance this very low rate longer-term debt with higher rate short-term debt that has the potential to creep up even higher as it will likely need to be refinanced at even higher rates in the future. This article implies that they would foolishly make this trade for policitial gain because they party in charge of the executive branch can goose up the stock market and housing market and brag about it. Wow. Just when you think the shenningans cant get any worse.

    • Koh Phi Phi

      On the other hand, unless I am reading the whole thing wrong, the Treasury would be buying off the low interest debt at a heavy discount: some of the off-the-run long term debt is currently trading at 60% of its par value. Granted, they would be paying a higher yield on the new debt, but they would be reducing the total size of the debt burden, as they’re effectively exchanging 60 cents worth of new debt for 100 cents worth of old debt.

      Can someone confirm whether I got this right or not?

  17. NeuroInvest

    We have had structural inflation exceed the ability for the treasury and FED to create any form of positive monetary outcome. In my view, buybacks seem like a last resort response to suppress inflation? Since above else, inflation seems to be their primary target, and the primary inhibitor to fixed income operations moving forward. Since all other factors in play here seem like an even worse course of action on the economy (financial repression), it seems like treasury buybacks would allow supply side economics to suppress inflationary pressures, at least temporarily? Am I on track here? What’s your thoughts?

  18. Engin YILMAZ

    Dear Wang

    My scenario: Treasury and Investor

    Treasury issues new debt:
    Increases TGA

    Investor sells its old debt to treasury:
    Decreases TGA
    Increases Reserves and Deposits

    Investor buys new debt from treasury:
    Increases TGA
    Decreases Reserves and Deposits

  19. Tony

    Hi- similar to FOMC meetings on Federal Reserve balance sheet outlook, is there somewhere I can look to understand the Treasury’s point of view on Treasury General Account balance sheet going forward? It seems to affect the bond market significantly. Thank you

  20. Anonymous

    Bernanke disabled the brakes on the car – and got a “nobel prize” ( lower case) for it. Various games may be played shifting this and that. The end game is coming into view.
    The end game is a new currency system – CBDC – that will have programmable currrency at its base. And total social control at a micro level.
    Enjoy!

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