A change in the underlying plumbing of the financial system is making it unlikely that QT can run its expected 2+ year course. An ideal QT would drain liquidity in the overall financial system while keeping liquidity in the banking sector above a minimum threshold. That is only possible if the bulk of the liquidity drained is sourced from the $2t RRP, which holds funds owned by money market funds. MMFs could facilitate QT by withdrawing funds from the RRP to invest in the growing supply of Treasury bills, but recent data suggests they have lost interest in bills. Households appear to have replaced MMFs as the marginal buyer of bills and are funding their purchases out of funds held in the banking sector. This suggests QT may lower banking sector liquidity below the Fed’s comfort level much earlier than anticipated. This post illustrates the emergence of households as the marginal investor in bills, suggests the change is due to high MMF fees, and discusses its implications on the path of QT.
Households Are the Marginal Buyer
The marginal buyer of short-dated Treasuries over 2022Q3 appears to surprisingly be U.S. households. Federal Reserve data show that household purchases of Treasuries surged to record levels on a seasonally adjusted annual basis as MMFs notably shrank their holdings. Note that the “household” category includes hedge funds, but circumstantial evidence suggest that they were not major investors in Treasuries. Hedge funds are usually not major investors in bills and tend to finance Treasury purchases in the repo market, where volumes were little changed over the quarter. Regardless, hedge funds account for less than 10% of household financial assets.
The overall household balance sheet suggests that households rebalanced out of their savings accounts and riskier investments into Treasuries. Treasury bills are substitutes for savings deposits and CDs, which both are offering returns much close to 0% than comparable Treasuries. A shift by households into bills is particularly plausible as MMFs notably decreased their bill holdings even as overall bill issuance rose. Interestingly, households passed over MMFs in their search for safety and yield.
Households likely decided to pass over MMFs due to their rising fees. MMF fees follow a cycle where managers waive fees when interest rates are low to retain clients, but charge full fees when interest rates are high. One $200b MMF is even charging a 0.59% fee ($1b+ a year) to press the buy button at the RRP Facility each day. Households could do much better by owning Treasuries directly.
Better than Bills
MMF’s loss of interest in bills will make an ideal QT more difficult. MMFs have steadily rotated out of Treasury bills and into the RRP and Agency discount notes throughout the year. The expected path of the RRP offering rate and Agency DN yields are both higher than bill yields. The supply of Agency discount notes has surged in recent months as Federal Home Loan Banks increased their annual debt issuance by $500b to record levels. This allowed MMFs to invest maturing bill proceeds into DNs and maintain their RRP allocation, but the historic surge in DN issuance is unlikely to be repeated next year. MMF may go back to rolling the proceeds of maturing bills into the RRP unless bill yields rise significantly.
With MMFs showing little interest for bills, repo lending is now the only pipeline through which the RRP can be drained. Recall, MMFs are highly constrained in their investment options and can only invest in very safe assets. Other than bills and DNs, they can also withdraw money from the RRP and lend in repo. Demand for repo financing has ticked up slightly over the past few months, but it will never come close to draining the $2t in the RRP. The RRP cannot be drained without a major allocation out of the RRP and into bills.
The emergence of households as the marginal bill investor suggests that future bill issuance will be an additional drain on banking sector liquidity. While bills purchased by MMFs would have been funded by withdraws from the RRP, households fund their investments out of funds held in banks. Households have $10t in savings deposits and their continual bid can keep bill yields unattractive to MMFs even as bill issuance rises. The marginal investor in Treasury coupons the past year already appeared to be financing their purchases from funds held in banks, now the marginal bill investor is as well.
The Fed’s aggressive $95b a month QT program was premised on tremendous amounts of excess liquidity in the $2t RRP keeping bank reserve levels above an estimated $2t minimum. Our understanding of the financial system always suggested draining the RRP was unlikely, but now it is looking very unlikely. QT is effectively proceeding with bank reserve levels ~$1t above target and no excess. In this scenario QT can only last several months.