personal views of a former fed trader

Who’s Still Borrowing?

The demand for money market funding across all major borrowers is declining even as the supply of money market funding continues to increase. Prior posts described the structural forces increasing the supply of money and pushing money market rates lower, but declining demand for money plays a role as well. The vast majority of money market borrowing is from the U.S. Treasury, GSEs, repo dealers and commercial banks. They have all been reducing their borrowings in money markets, with some reductions likely structural. In this post we review each of these major borrowers and explain why their borrowings have declined.

U.S. Treasury

Treasury is the single largest borrower in money markets with ~$4t in bills outstanding. Its borrowings have been declining because coupon supply has increased and because the Treasury is paying down debt ahead of a potential debt ceiling episode. Treasury issues debt on a “regular and predictable” framework, which in practice means it seeks to maintain stable coupon issuance (reviewed quarterly) and meets unanticipated financing needs by issuing bills. Longer tenor debt is more difficult for the market to digest, so predictability helps auctions go more smoothly. Treasury largely funded last March’s unanticipated $2.2t CARES Act through a surge in bill issuance, but subsequently significantly raised its coupon issuance. Treasury seeks to fund at the least cost over time, so it makes sense to lengthen debt maturities when rates are around historical lows. As financing from coupon issuance increases, Treasury has less need to issue bills.

In August the Treasury will likely stumble into another debt ceiling episode, where it will be have to keep debt outstanding below a certain threshold (there are always accounting tricks to find more headroom, so its not clear what the exact threshold is). Just as emergency financing needs are met through higher bill issuance, emergency cuts in financing are met with lower bill issuance. It will reduce debt by paying down bills using TGA cash. Treasury’s current target of a $450b TGA account at July month-end suggests a ~$300b decline in bill supply (TGA is around $750b now).

Bill supply can bounce back after the debt ceiling, especially if there are more fiscal stimulus bills. But that would be after an steep upcoming decline.

Government Sponsored Enterprises

GSEs have historically been large borrowers in money markets, with aggregate borrowings over $1t pre-GFC. They have a smaller but still substantial footprint today that is declining due to lower business needs. Among the GSEs, Federal Home Loan Banks (“FHLBs”) are by far the dominant issuer of short-term GSE debt. (Pre-GFC, Fannie and Freddie were also large issuers, but scaled down borrowings as their investment portfolios were wound down during conservatorship.) FHLB money market issuance has steadily declined from $800b in early 2020 to around $500b today.

The primary purpose of FHLBs is to provide cheap funding to domestic banks. FHLBs borrow from money markets at a rate slightly higher than bills, add on a small fixed spread, and lend the money out on a secured basis to domestic banks. Their debt issuance is thus in proportion to the demand from banks for funding. As the banking system overflows with liquidity, banks have less need for funding. This in turns means there is less demand for loans from FHLBs, which in turns means less FHLB borrowing from money markets. This trend is likely structural and will continue as long as QE continues to fill the banking system with liquidity.

Repo Dealers

Repo dealers usually borrow trillions from money markets, but their borrowings appear to be trending lower from reduced financing demand from hedge fund clients. Repo dealers borrow through a repo transaction, which is essentially a secured loan (usually with Treasury or Agency MBS as collateral). The money is used to fund their own securities portfolio or to fund loans to their hedge fund clients via a matched book transaction. In a matched book transaction the dealer borrowers from a cash investor via repo, and then lends the money onwards to their hedge fund clients also via repo.

The repo market has many segments, with the largest segment by far the ~$1t market for overnight loans secured by Treasury collateral. The Fed’s index for that market is the Secured Overnight Financing Rate (“SOFR”). SOFR volumes have been gradually declining, with the decline corresponding with lower Treasury holdings by hedge funds. This suggests that there is less demand for financing from the hedge fund community, potentially due to lower interest in the cash-futures basis trade. (A recent paper attributed a large portion of hedge fund Treasury holdings to the cash-futures basis trade, where investors buy Treasury securities with repo funding for delivery into futures contracts.) That trade performed poorly last March, so investors may have scaled it down in light of newly discovered tail risks.

Commercial Banks

Commercial banks borrow from money markets through a number of avenues, but currently have a little need to borrow as the banking system is overflowing with QE liquidity. A recent Fed survey suggests banks reduce their money market borrowings when they have more than enough liquidity. This behavior can be seen from the steadily declining large time deposit volumes since early 2020. This trend will likely persist as long as QE continues.

Fed is Ramping Up Borrowing

If there is not enough demand from the market, then front-end money flows into the Fed’s RRP. The Fed is technically “borrowing” the money, but it is more accurate to describe private investors as depositing money overnight at the Fed because they have no where else to put it. The transaction is initiated by investors, and cash is returned the next day.

Some of the decline in demand for money market cash is temporary and some is structural. But at least in the coming months, the supply demand imbalance is set to worsen and continue to put downward pressure on dollar money market rates (and increase ON RRP participation).

13 Comments

  1. demirhan demir

    So shifting demand of source of borrowing causes a decline in MMs rate. Should it be expected beforehand? And what are the possible harms/deteriorations of that shift on money markets? What can this shift lead to? Thank you!!

    • Joseph Wang

      I don’t think there’s anything to be concerned about, short rates will just stay around the RRP offering rate and RRP participation will continue to climb.

  2. George

    Hi Joseph,

    As always, a very articulate and well thought out piece. One thing I was curious to learn about is how long you think this dynamic goes on for? For one, the re-issuance of bills/bonds on the back of both the debt limit resolution as well as the additional fiscal stimulus the Government wants to do, is one element that could push against these other forces. But are there any other things that could occur in any of the above various market participant’s world that could push money market rates higher? If so, what and when?

    Thanks in advance

    • Joseph Wang

      I think its very hard to short rates to go higher because there is just too much cash looking to be invested. As you mention, the Treasury can start issuing bills after the debt ceiling (and a lot of them if there’s another fiscal package). Hard to say when the debt ceiling is resolved as it is a political choice, but at most a few months.

      But I don’t think anyone else would increase borrowing. Bigger picture – money markets become zombified and most short rates trade at RRP offering, with bills a few bps below.

      • George

        how much of an effect do you think tapering (if/when that happens) will have on MM rates in the short term and medium term? I’m on the same page as your last post about FRA/OIS tightening as long as cash continues to be added, but beyond that timeframe it’s a lot more fuzzy.

        • Joseph Wang

          I think the stock of liquidity is more important than the flow for MM rates. So taper won’t matter, but QT would (if it ever happens).

  3. RB

    Hi Fedguy,

    What about non-financial corporations borrowing in the money market? They drew down hard on their credit lines in march 2020 and thus issued far less Commercial Paper – but there seems to have been an uptick again. Can you comment on whether you think non-fin CP rates will ever rise again? And is there any relation between non-fin CP rates and the RRP rates?

    • Joseph Wang

      Good points! I think all money market rates will remain low (as a spread to RRP) for the foreseeable future. They can rise if QT ever happens. The non-financials did draw down hard on their credit lines last March, but many then borrowed from the capital markets when things normalized. Given where longer term rates are it makes sense to lengthen their maturities. The RRP affects the opportunity costs of all money market participants, so an increase in RRP will also increase a non-fin CP rates.

  4. Bob Bishop

    …SOFR volumes have been gradually declining, with the decline corresponding with lower Treasury holdings by hedge funds. This suggests that there is less demand for financing from the hedge fund community, potentially due to lower interest in the cash-futures basis trade. ….
    or simply because the Fed bought them all back ?

    • Joseph Wang

      Maybe, but if that’s the case that also means there are fewer tsy to finance via repo loans. So lower SOFR volumes.

  5. ming fang

    Joseph,

    Zoltan @ Credit Suisse is saying this explosive growth in RRP is very bearish for risk assets as it sterilises liquidity by prking it on fed balance sheet. Do you agree?

    • Joseph Wang

      I don’t see it that way. It does reduce liquidity held by banks, but not from the non-bank sector. Non-banks have a Fed RRP as an asset, which is a cash equivalent. I’ll write about this in an upcoming post.

      • RB

        I suppose the proof is in the participant break-down data. I understand that the data is collected quarterly (and thus lagging) – but would Zoltan be able to base his claim on proprietary data out of Credit Suisse, due to his in-house position?

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