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 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.
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.
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.
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.
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.