personal views of a former fed trader

The Marginal Buyer

Treasury buybacks would be a powerful tool that could ease potential disruptions arising from quantitative tightening. The Treasury hinted in their latest refunding minutes of potential buybacks, which is when Treasury issues new debt to repurchase old debt. Buybacks can be used to boost Treasury market liquidity, but more importantly also allow Treasury to rapidly modify its debt profile. By issuing bills to purchase coupons, Treasury could strengthen the market in the face of rising issuance and potentially structural inflation. An increase in bill issuance would also facilitate a smooth QT by moving liquidity out of the RRP and into the banking sector. This post reviews the basics of Treasury buybacks and explains how it could be an important tool in managing Treasury market stability and Fed liquidity flows.

Treasury Buybacks 101

A Treasury buyback is when the Treasury purchases previously issued Treasury debt in a secondary market transaction. The purchases can be financed out of fiscal surpluses, or by raising additional funds through debt issuance. Buybacks can potentially improve market liquidity by placing a steady bid for less liquid Treasuries in a way similar to QE. They can also reduce the overall interest expense of debt if higher interest debt is purchased with the proceeds from issuing lower interest debt.

Buybacks change the debt profile of Treasury

Buybacks were last conducted in 2000 and recently floated as an idea to boost faltering Treasury market liquidity. In 2000, the Treasury ran a fiscal surplus and used the extra funds to reduce interest expenses by buying back $67.5b of debt. Most recently, the Treasury is exploring buybacks as a solution to anemic Treasury market liquidity. Market liquidity has declined to historically low levels, in part due to regulatory constraints limiting dealer intermediation capacity. The Treasury suggests buybacks could improve market functioning and reduce issuance costs.

Treasury market liquidity is very poor. Source: TBAC.

But beyond the stated benefits, a buyback program funded with bills could be a powerful tool to manage QT by strengthening the Treasury market and topping up liquidity in the banking sector.

Reenforcing the Bedrock

QT is occurring at a time when the Treasury market appears to be vulnerable from both fundamental and technical factors. The Treasury market has become very rate sensitive from both historically high WAMs and low coupon interest rates. If inflation is persistent, then the expected higher interest rates would impose significant loses on investors. In addition, Treasury issuance is expected to remain exceptionally high even as market liquidity remains historically poor. This is a recipe for significant volatility in what is considered a foundational safe asset in the global financial system. Volatility and losses in the Treasury market would in turn bleed into all asset classes as they did in March 2020.

WAM is at historical highs and rates have been historically low. Source: TBAC

Buybacks can strengthen the Treasury market by boosting liquidity and reducing interest rate sensitivity. The March 2020 Treasury market panic began with a spike in yields and ended with the Fed as dealer of last resort. In theory, the Treasury would be able to act in a similar role by issuing bills and using the proceeds to buy coupon Treasuries. Money market funds would easily absorb the bill issuance much like the banking sector easily absorbed the additional reserves. The Treasury would in effect become the dealer of next to last resort while reducing the market’s overall sensitivity to interest rates. This would also free the Fed to maintain a restrictive monetary policy amidst market disfunction.

Reserve Pump

Buybacks funded by bill issuance can help redistribute liquidity so that QT can proceed more smoothly. The Fed controls the quantity of liquidity that QT drains, but it does not have control over how it is drained. At the moment, QT is draining liquidity in the banking sector rather than the excess liquidity held in the RRP. This can be potentially disruptive because that liquidity is not necessarily excess, but might relied upon by someone in the financial system. Buybacks funded by bills would steadily pump the $2.2t held in the RRP into the banking system. This would facilitate a smooth QT by helping the banking sector maintain a high level of liquidity.

Buyback moves funds from RRP to banking sector via TGA (T-account not shown)

Defusing the Timebomb

A buyback program funded by bill issuance would offer around potentially $1t in buying power to ease potential disruptions from QT. The Treasury aims to have 15 to 20% of its outstanding debt in the form of bills, which is currently around 15% of debt. This gives the Treasury potentially around a trillion in space to reshuffle its debt profile. That should provide meaningful support to the Treasury market and boost banking sector liquidity.

But at the end of the day, Treasury issuance is expected to grow by over $1t+ a year forever. No amount of buybacks can support an asset whose supply is virtually infinite. That’s a job for someone else.

Treasury issuance is projected to grow $1t+ a year forever. Source: U.S. Treasury

43 Comments

  1. Ravi Shanker

    In FY2021, the Fed had a net income of $107 Bn which it returned to the US Treasury as required by law.
    If the Fed raises its administered rates ( IORB and interest on RRP) to 3.5% , on a total of $5.6 T ( Reserves=$3.1 T , RRP=$2.5 T) , the Fed’s interest expense would be about $200 Bn.
    If such rates were maintained for the next 12 months, the Fed would run a loss of about $100 Bn/yr.(negative net interest income)
    So, not only will it return zero to the US Treasury in the coming year, it will continue to return zero in subsequent years until the deficit is made up.

    So , the Fed is paying out IORB to the banks and interest on RRP to the mmf at the expense of the US Treasury.
    ( this looks like a closet fiscal stimulus targeted at the banks and mmf !!)?
    Moreover, if the US Treasury reshuffles its liabilities as you suggest, the interest expense will rise ( since we have a negative sloping yield curve).

    It may be worth focusing on the budget deficit, and the ramifications of the Fed running a negative net interest income.

    • Anonymous

      Fed doesn’t have a mandate to run a positive P&L, period

      • Ravi Shanker

        Sure, except a negative P&L is ultimately paid for by the taxpayer. The US Treasury will not receive any more $100 Bn/yr payments from the Fed for possibly several years, until the cumulative deficits at the Fed turn positive.
        So the Fed “rate policy” is adding $100 Bn/yr to the budget deficit. Possibly for several years.

    • AB

      How long can the Fed run a negative net interest income position?

      • Ravi Shanker

        Thanks, I was starting to think no one was focusing on this other than me! This is a first in Fed history. Maybe they are hoping to do a short sharp “rate hike” , enough to tank everything, so they can start cutting “rates” early next year back below 2%. If they magically manage to keep the average “rate” below 2% for FY2022 and FY2023 , they can avoid the whole issue. (FY ends in Sept).
        FY2022 should be Ok since the FFR was 0.25% until May . FY2023 will be more the issue since it will start out at something like 3%, they would need to start cutting it back to around 1% starting early next year to average out under 2%.

        • AB

          Thanks for the reply, very interesting what you say about the outcome if they keep the average to 2%. I’m interested in the equity market implications so come at this from a more limited understanding. My previous thought was that they need to un-invert the yield curve somehow…if inflation is persistent they can’t cut the short end and the market determines the long end. So some form of operation reverse twist? Would it have the desired effect to outright sell long bonds currently on the balance sheet a more aggressive version of QT, getting the long end in the 3.5-4.0% range? 10yr almost hit 3.5% in the middle of June I think. Possible??

          • Ravi Shanker

            On equities , I am getting a distinctly 1937 feeling ! I think we are in for a very rough next few months. Dont forget the “rate increases” are only one tool, the Fed is also going to kick QT up bigly in Sept ($95 Bn/mo). The Fed will use QT to do the nasty business of crashing things, so they wont have to raise rates like Volker.

          • Ravi Shanker

            The problem is after a decade of massive underinvestment in oil, supply is just not able to respond. So they dont want people all happy and feeling rich on their stock portfolios and driving around and flying on vacations. They want people hunkered down and defensive and thereby cut demand.
            China is already showing cracks from the property bubble. Europe is in a downright energy emergency. Its so bad the Massters Of The Universe are considering changing the name of ESG policies to “sustainablity”. Narrative management , optics – to try to counter the building anger that they never had a Plan B once they killed off oil/gas.

    • Koh Phi Phi

      Ravi said: “So , the Fed is paying out IORB to the banks and interest on RRP to the mmf at the expense of the US Treasury. ( this looks like a closet fiscal stimulus targeted at the banks and mmf !!)?”

      Yeah, it seems pretty intuitive: the higher the interest rates, the larger the budget deficits required to fulfill debt obligations, regardless of whether said obligations come from bond issuance, interests on reserves, reverse repo, etc. Right?

      • Ravi Shanker

        No , thats why its better to think about balance sheets and income statements rather then “intuition”.
        Also, at least for now, the Fed and the US Treasury are separate entities. The Fed is owned by its shareholders who are the major banks. The US treasury is “owned” by the citizens.

        • Koh Phi Phi

          Ravi, thank you for your response. Could you please elaborate a bit further on what is incorrect in my earlier post? I am eager to learn.

          Regarding your second statement, I disagree. Unfortunately, while the Fed is technically an independent entity and it is indeed owned by the banks, the reality is that the Fed chairman is appointed by the President and he responds to the Congress. Furthermore, its current dual mandate was actually dictated by the Congress in the 1977 ammendment of the Federal Reserve Act . For all those reasons, the Fed is in reality a 100% political institution.

          • Ravi Shanker

            Thanks – lovely island you live on , I loved Thailand when I lived in Asia!
            Prior to 2008, when the Fed “raised rates”, they did it by selling securities to the banks, withdrawing Reserves, thereby driving up rates in the Fed Funds market.
            Now, the way the Fed raises rates is utterly different. Because we have NO reserve requirements and the Reserves are about $3 Trillion more than the banks would need even if there was a reserve requirement. So, the Fed simply pays the banks more money as IORB, and interest on the RRP.
            Bond yields going up is somewhat different. The US Treasury would be paying the increased interest sure. That is as it has always been.
            The difference now, is due to the massive QE since 2008, the Fed owns a huge amount of Treasuries/MBS, but until this year the US Treasury was effectively paying nothing on those Treasuries, because the net interest earned by the Fed was simply returned to the US Treasury.
            Now, because of IORB, the US Treasury is effectively paying interest on all those Treasuries accumulated since 2008.
            Why? Because the Fed will have negative Net-interest income if it is paying more than 2% as IORB/interest on RRP, and therefore will return zero to the US Treasury.

          • Ravi Shanker

            As far as being an independent entity, the Fed is independent as far as the accounting goes. I agree that it is political, the Fed Chair is appointed by the President etc.
            If you want to think of the Fed and US Treasury as merged into one entity ( lets call it Ministry Of Finance , MOF) things get interesting:
            In that case, during QE , the MOF was simply buying bonds from the market and issuing freshly printed money in exchange!
            And now, the MOF is simply paying the banks and money market funds more money as IORB/interest on RRP) , increasing the budget deficit .
            ie. The MOF is taking money from the US taxpayer , handing it to the banks and calling it a “rate increase”!
            Not sure merging the two entities makes things look any more kosher, in fact it simply makes plain whats really going on.

          • Ravi Shanker

            Slight correction , about how QE may be viewed in a “merged entity” scenario:
            The MOF , instead of issuing Treasuries to raise money, was simply printing the money. Why? Because one department at MOF was issuing Treasuries to another department which would then supply the fresh cash! The Treasury issuance was just a cosmetic device, the MOF was actually just printing money and spending it.
            In addition the MOF was buying MBS from the market and paying for it with freshly printed cash. And the MOF was keeping the interest it received on those MBS.

            “Printing Cash” is shorthand for , MOF was printing something called “reserves” and making banks buy it , opening a matching deposit account in favor of the MOF in excahnge.

            Now in 2022, MOF is paying the banks “Interest On Reserves”. So printing more cash and handing it to the banks. You can call it IORB or Christmas Gift does it matter? Its cash that moves from the MOF to the banks.

            How about QT? As far as “letting the balance sheet rolloff”, lets see, since Treasureis issued during QE were just an inter-departmental cosmetic device within the MOF, its just a small accounting adjustment within the MOF that has zero effect on anything outside the MOF.

            None of this is going to fix the energy crisis brought to you by the Massters of ESG.

          • Ravi Shanker

            As long as we are playing with hypothetical scenarios, why not consider surgically cutting out the deposit taking part of the commercial banks and merging it with the MOF. ie. transfer Reserves and Deposits out of the banks to MOF.
            Banks can then all become investment banks, trading houses etc. Get rid of FDIC and all the other frofrah associated with the commercial banking system.
            So now , there is no need to go through the rigmarole of the MOF selling “reserves” to the banks in exchange for a deposit.
            Now in the supermerged entity ,MOF allows all citizens to have accounts directly at the MOF. The MOF collects taxes, pays the military, soc security etc etc and prints money if the taxes dont suffice. Now “printing money” means it simply credits the appropriate deposit account at the MOF.
            The whole thing will be elctronic and accessed via apps on iphones.
            MOF will add and remove money from your deposit account as it sees fit and depending on your Social Credit Score, Health Mandate ComplianceScore, Carbon Foot Print score etc. Well behaved citizens who follow every directive issued have nothing to fear.
            Such a scheme may then be affectionately known as Central Bank Digital Currency.

        • Koh Phi Phi

          Ravi, thank you very much for your detailed explanation on how the accounting flows between the Fed, the Treasury and the commercial banks work. It has helped me understand how it works! Also, thank you for describing the theoretical path towards a CBDC should the Fed and the Treasury ever merge… to be honest, it’d be a scary future for the citizenship at large… Let’s hope it doesn’t materialize.

          One final question if I may, please: you’ve stablished that 2% is the break-even threshold between A) the average coupon received by the Fed from the bonds+MBS held at its balance sheet and B) the interests paid out by the Fed through IOBR+RRP. Furthermore, you’ve stablished that for as long as the Feds Fund remain above 2%, the Fed will be a constant source of deficit budget for the taxpayer. I understand your rationale, and I agree. However, here’s a theoretical question: since the Fed’s revenue comes entirely from the public sector in the form of govt-bonds and agency-backed MBS (meaning no private sector, whether corporate bonds or stocks, as per the Federal Reserve Act), doesn’t that mean that any Feds Fund above 0% is, effectively, deficitary?

          Again, thank you for sharing your knowledge with the rest of us 🙂

          • Ravi Shanker

            Thanks. Its true that the overall interest paid on outstanding public debt adds to the fiscal deficit, , but remember a Fed rate increase does’nt translate into an interest rate increase across the entire $22 T or so in public debt outstanding! ( Iam subtracting the $5 T or so in intra governmental securities). It only affects future Treasury issuances. And so far after 150 bp “rate increase” the 10 yr Treasury yield is still LOWER by 50 bp. (since June 15).
            So its not obvious what the actual rates in the real world will be as the Fed increases “rates”. The Treasury could issue 10 yr notes today at a yield than on June 14 , before the aggressive 150 bp “rate increase”.

          • Ravi Shanker

            OOps
            ” The Treasury could issue 10 yr notes today at a LOWER yield than on June 14 , before the aggressive 150 bp “rate increase”.

  2. Ravi Shanker

    Since June 15, 2022 the Fed has raised its administered rates by 150 bp.
    Since June 15, 2022:
    The yield on the 2yr Treasury has declined by 20 bp
    The yield on the 10yr Treasury has declined by 70 bp
    The S&P500 has gone up by 16%

    So I guess the Fed paying banks more money as IORB and paying mmf more money as interest on RRP has resulted in a rather large loosening of financial conditions.
    Why is this considered a “tightening”?
    Why would this do anything to reduce inflation?

  3. Toz

    There is a difference between a buyback paid for by a surplus and direct monetization or coupon swapping. Once the market sniffs this out, if it were to happen, then on the run Treasuries would loose their liquidity premium.

  4. Mr Risk

    Fed Guy: One thing that does not quite mesh here is to think of the Fed/Treasury in the sense of a consolidated balance sheet. The bank reserves are a liability of this consolidated balance sheet. Therefore, the WAM is much lower than what the charts indicate.

  5. Spencer Bradley Hall

    Operation Twist?

    • Mike

      Operation “Reverse” Twist… sell 10 Year UST and use proceeds to buy Bills to counter inversions

  6. max

    Bottom line……bullish or bearish on equities?

    • RLC

      Bullish for bank stocks? The potential unleashing of fractional lending on more reserves would be inflationary no? If so bullish on hard assets once again too?

      • Ravi Shanker

        We dont have a fractional reserve” banking system
        The reserve requirement was removed in March 2020.
        Banks have not been reserve constrained for decades
        Banks are not anxiously waiting for more reserves so they can start lending!
        When a bank makes a loan – it simply creates an asset called “loan” and a matching deposit “deposit in RLC’s favor”
        Nothing is going to be”unleashed”!

        • Kanefire

          so you are saying “the asset called loan” doesn’t get rehypothicated to create more lending with banks pushing out risk profile due to greater spreads? what is the value of banking liquidity then?

        • Spencer Bradley Hall

          re: “Banks have not been reserve constrained for decades”

          That’s wrong. I predicted both the flash crash in stocks and the flash crash in bonds using required reserves, 6 months in advance and within one day.

    • Ravi Shanker

      The stock market is a strange thing. The Fed “raised rates” by 150 bp since June 15, and we have had a rip roaring rally in stocks since then.
      And now people are hoping the Fed “pivots” after the brutal , historic, aggressive tightening?
      Why? Dont people like rip roaring rallies?

      • Spencer Bradley Hall

        The FED won’t have to pivot. M2/Gross Domestic Product (potential AD) is still too high:
        https://fred.stlouisfed.org/graph/?g=eTtE

        Stagflation is the most probable outcome.

        • Spencer Bradley Hall

          N-gDp is still too high:
          2020-07-01 38.7
          2020-10-01 6.6
          2021-01-01 10.9
          2021-04-01 13.4
          2021-07-01 8.4
          2021-10-01 14.5
          2022-01-01 6.6
          2022-04-01 7.8

  7. Stephen W. Shipman, CFA

    Under the last graphic, it is asserted that the RRP’s convert to reserves in the banking system. Currently, the RRPs are a holding ground for Excess Reserves (ER) and thus are precluded from being managed by the commercial banks. If these ER convert, the base money (Currency and Required Reserves) is likely to expand exponentially as banks are incentivized to LEND money, at the margin, to increase its net interest on the reserves. This is not dissimilar to the problem of base money creation of the ’70s that lead to the disastrous inflation.

    • Ravi Shanker

      RRPs are simply a place for your money market fund to earn some interest.
      If you write a check to Vanguard money market fund. Vanguard’s bank transfers Reserves to the Fed. Vanguard Money Market Fund then has a direct deposit ( effectively) at the Fed called RRP. ( take a look at Vanguard money market fund holdings – you will see that more than half the fund is invested in reverse repos.)
      On the liability side of the Fed’s balance sheet Reserves go down, RRP goes up.

      There are no “excess reserves” . We dont have a reserve requirement since March 2020 ( Zero). All reserves are in excess.
      Banks dont expand their lending as reserves increase or decrease. Reserves have no effect on their lending.
      When a bank makes a loan – its simply a ledger entry : Loans go on the asset side and a matching deposit is created on the liability side. thats all.

      Reserves just sit , inert, on the banks balance sheet as they await the Fed’s next cunning plan! But now they are earning a nice 2.5% interest from the Fed.
      Banks expand lending if they can find profitable , low risk loans to make.

      The Fed “raises rates” by paying the banks more money ( Interest On Reserve Balances), and more money to the money market funds ( interest on RRP).
      Thats all they do when they raise rates.

      The only similarity to the 1970s is they also used double entry book keeping like we do now.

    • Spencer Bradley Hall

      re: “the base money (Currency and Required Reserves)”

      No, base money was equal to required reserves only. An increase in the currency component is contractionary.

  8. Going John Galt

    Considering current WAM wouldn’t it be a structurally flattening force?

  9. Darin Tuttle

    This is true- when the Atlanta Fed paper came out I did a brief summary back in July.

    https://newsletter.tuttleventures.com/p/a-potential-fed-put?r=m53f8&utm_medium=ios

  10. Jim Miller

    How is this different from operation Twist? It seems the goal is to lower long-term rates and raise short-term rates.

  11. Spencer Bradley Hall

    H.R.4616 – Adjustable Interest Rate (LIBOR) Act of 2021
    https://www.congress.gov/bill/117th-congress/house-bill/4616/text

    Maybe the act is partially responsible for the $’s rise, as the E-$ market contracts?

    U.S. Dollar Index (DXY)
    Last Updated: Aug 18, 2022 at 5:15 p.m. EDT
    107.50
    0.92 0.86%
    PREVIOUS CLOSE
    106.57

  12. Koh Phi Phi

    Hey Joseph, thanks for the great article.

    Please correct me if I am wrong, but if the Treasury issues an extra dose of short term bills to buy up a bunch of old 10yr bonds from the open market… won’t they sink the yield curve deeper into inversion? Is that something they’d really want to do?

  13. Ravi Shanker

    from the federalreserve.gov website – on “Dividends” :
    This section provides that the earnings of the Federal reserve banks shall be used for the following purposes in the order named:

    (1) For the payment of or provision for expenses.

    (2) For the payment to stockholders (who are member banks exclusively) of cumulative dividends at the rate of six percent per annum on paid-in capital.

    (3) For creating and adding to a surplus fund until such fund equals 100 percent of subscribed capital.

    (4) The balance to be paid 90 percent to the United States as a franchise tax and 10 percent into surplus.

    The question for determination is what are the rights of a Federal reserve bank with respect to the payment of dividends when the bank has already accumulated a surplus out of its past earnings but has failed during some subsequent year to earn a sufficient amount to pay the full dividends for that year.

    No payment can be made into the surplus fund unless the earnings for the current year are sufficient to pay in full the dividends for that year and any dividends for past years that may remain unpaid. Thus Congress has directed that the payment of current and past dividends shall take precedence over the accumulation of a surplus fund. In the absence of any indication to the contrary, it would be natural to assume from this that Congress intended also that the payment of current and past dividends should take precedence over the maintenance of a surplus fund already accumulated.

    It is to be noted that the provision in the second paragraph of Section 7, regarding the disposition of the surplus fund in the event of the dissolution or liquidation of a Federal reserve bank, makes it clear that the surplus fund of a Federal reserve bank will be available ultimately to pay the cumulative dividends in full.

    It is clear also that the payment of dividends out of surplus can result in no loss of revenue to the United States, for no franchise tax can become due until the six percent cumulative dividends have been paid in full. If the surplus should not be used to pay dividends for a year in which the current earnings are insufficient for this purpose, the back dividends would have to be paid out of future earnings before the United States becomes entitled to any franchise tax. In fact, the failure to pay dividends out of surplus in excess of 100 percent of subscribed capital would result in loss of revenue to the United States; because if dividends for any year should remain unpaid, they would have to be paid in full out of the earnings of future years before any franchise tax becomes payable, whereas, if dividends should be paid out of the surplus and the surplus were not thereby reduced below 100 percent of subscribed capital, future payments into the surplus fund would amount to only 10 percent of future earnings over and above current dividend requirements, the other 90 percent being paid to the United States.

  14. rsm

    Ravi said:

    《The MOF is taking money from the US taxpayer》

    Is this an abuse of language? What taxpayer was ever debited to pay for QE or IORB? Haven’t taxes actually gone down (Trump tax cuts)?

    Ravi also said:

    《MOF will add and remove money from your deposit account as it sees fit and depending on your Social Credit Score, Health Mandate ComplianceScore, Carbon Foot Print score etc. Well behaved citizens who follow every directive issued have nothing to fear.
    Such a scheme may then be affectionately known as Central Bank Digital Currency.》

    Is Know Your Customer in this vein, so the private sector is vulnerable to this same threat?

    And why shouldn’t we be fore-warned and fore-armed, voting only for candidates that support truly Unconditional Basic (CBDC) Income?

  15. Ali

    I’m a little confused. Isn’t the whole point of this exercise to fund the securities that are about to run off the fed’s balance sheet? So the US govt doesn’t have fiscal surplus to do this, it has to issue debt, its their choice to either issue bills or Notes or bonds to do this. If the point is that they should issue bills (because money markets can facilitate this by using their RRP account balance at the Fed), isn’t it as simple as them issuing the bills and using the proceeds to pay back the Fed? How does the private investor with the old UST come into this?

  16. Andyos

    Hi Joseph,

    I read this post again recently and it got me thinking about the “unloved” 20Y UST … and that the treasury buyback could be used to normalise this section of the yield curve. This was also alluded to in a previous comment about the on-the-run premium (albeit as a side effect).

    In other words, treasury buybacks are yield curve control.

    What would it take for this to transition from talk to reality? I think it would require a catalyst, for example some accident, resulting in a disorderly sell off in the treasury market.

    Or maybe we just need to reach a tipping point … where there is not enough outside interest to support the supply. Judging from the strength of the recent 7Y issue, maybe this is still a long way off?

Leave a Reply

Your email address will not be published.

© 2022 Fed Guy

Theme by Anders NorenUp ↑