An aggressive quantitative tightening (“QT”) pace would set the stage for another spike in rates, but this time further out the curve. During QT, the U.S. Treasury increases its borrowing from the private sector to repay Treasuries held by the Fed. While the Fed can be repaid with cash held in either the RRP or banks, the current issuance structure suggests repayment will largely come out of the banking system. The lesson of the prior QT was that reducing the cash balances of banks directly impacts markets that were recipients of that cash. In 2019, banks were pouring their extra cash into the repo market amidst surging demand for repo financing. The repo market broke when QT siphoned that extra cash away. This time around banks have poured their cash into Treasuries and Agency MBS amidst surging issuance. In this post we explain why QT will primarily drain bank cash balances, review the September 2019 repo spike and suggest that the stage is set for a potential spike in longer dated rates.
QT Will Drain Bank Cash, Not RRP Cash
QT will reverse the QE driven growth of RRP balances and bank cash balances, but the reduction will be tilted towards bank cash balances. The $1.5t in the RRP is deposited by money market funds (“MMFs”) and can only be accessed via certain “pipes.” MMFs are mandated by regulation in invest only in safe short-term assets that include Treasury bills and Treasury backed repo loans. This means QT can only drain RRP balances if either the Treasury significantly increases bill issuance or if investors purchase Treasury coupons with financing from a repo loan. Otherwise, QT will drain cash held by banks as the additional Treasuries would be purchased by Non-MMFs with money held in banks.
MMF cash will likely not be a major source of funding for QT. The bulk of issuance used to repay Fed Treasury holdings will be in tenors that MMFs cannot purchase. This is simply due to Treasury’s goal that short-dated debt comprise 15 to 20% of its debt. Investors have also not shown interest in buying coupon Treasuries on leverage, with repo volumes essentially flat the past year despite record issuance. Together this suggests RRP balances will remain high as QT will mostly drain cash held in the banking sector.
September 2019 Repo Spike
In 2019, demand for Treasury repo financing drove repo rates higher and enticed banks to enter the market as the marginal lender. Repo volumes rose from $800b a day in 2018 to almost $1.3t on the eve of the repo spike. The higher demand pushed repo rates above interest on reserves, which is the return banks were earning on their cash balances at the Fed. Noting that repo lending and cash have nearly identical regulatory treatment, banks shifted a few hundred billion of their cash balances into repo for a little extra return.
Banks were net lenders in the repo market, not borrowers. When repo rates spiked that meant repo borrowers (hedge funds and dealers) needed cash, but not banks. If banks were at any time short in cash should could just cut back their repo lending, but they did not. An extensive survey of banks consistently found that banks reported having far more cash than they needed. The impact of QT was felt not in the banking sector, but in the markets that grew reliant on extra bank cash. Repo rates spiked in September 2019 because demand for repo financing kept growing while QT was shrinking the supply of cash into the market.
The Next Spike
The mechanics behind the 2019 repo spike suggest that another spike in rates will eventually occur. Last time banks deployed their enormous QE cash balances into repo, but this time around they are pouring it into Treasury and Agency MBS securities to the tune of $1.5t. An aggressive QT will both rapidly increase the supply of duration to the market while at the same time rapidly reduce the cash balances of banks, a key marginal buyer. The combination of a positive supply shock and negative demand shock can eventually again lead to violent dislocations.
Note that QT would also be playing out in a context of rising rate hike expectations, rising energy prices, and a market depth that has not scaled anywhere near the surge in issuance outstanding. These factors all contribute to fragile market conditions that don’t matter until they do. The proposed $100b+ a month QT is very aggressive and its impact cannot easily be priced in advance. Risk markets had no idea what repo was, but a spike in rates would shake the foundations of the market.