Draining the Repo
#26: The Risk and Reward of Treasury Buybacks
For the past year, The Last Bear Standing has warned of the negative impact of the Reverse Repo Facility (RRP) and Quantitative Tightening (QT) on financial market liquidity. With QT running at full steam and the Treasury market thinning, both the Federal Reserve and the Treasury have now openly acknowledged these liquidity challenges. Now, we have a preview of the potential plan to remedy the situation – Treasury Buybacks. This week, we will outline the mechanics of Treasury Buybacks, the potential benefits and risks, and implications for the market. Let’s jump right in.
Slicing the Pie
Today, there are two key dynamics that impact dollar liquidity in financial markets.
First, is the total supply of dollars, or the total size of the Federal Reserve’s balance sheet.
Second, is the internal composition of the balance sheet - flows between the private financial markets, the Treasury General Account (TGA) and the Reverse Repo Facility (RRP).
In other words, you need to understand the size of the pie and how it’s sliced1. Today, let’s focus on a simplified breakdown of the Fed’s balance sheet into three categories.
The first two slices of the pie are the TGA (the Federal government’s checking account) and the RRP. These two accounts are held directly by the Federal Reserve. The remaining dollars outside of these two accounts are available in the private market2 and support the financial market as we know it.
Assuming no change in the total size of the Fed’s balance sheet, an increase in the balances of the TGA or RRP reduces the dollars available in the private market and vice versa. As more dollars are parked at the Fed, there is less liquidity available elsewhere.
Under normal circumstances, the size of the pie and the proportion of each slice is driven by several competing factors:
Total Balance Sheet: The Fed expands its balance sheet with QE and shrinks it with QT.
Treasury General Account: The TGA increases as the Treasury raises cash by issuing debt and decreases as government spending flows back into the private sector.
Reverse Repo Facility: The RRP is a fixed-rate facility which enforces the Fed’s overnight interest rate target. Theoretically, if overnight rates in the private market are lower than the interest rate on the RRP, then market participant will allocate more dollars towards the RRP (reducing private market liquidity in the process). Conversely, if private interest rates are higher than the RRP offer rate, than money should flow out of the RRP and back into private markets.
Financial Market Liquidity: Private markets are left with the remaining dollars.
Total dollar supply is easy to predict by the QE and QT schedules laid out by the Fed. But changes in the internal composition are more complex and involve competing variables and objectives. The dramatic decrease in private market liquidity over the past year has been driven primarily by these internal shifts, rather than the small reduction in aggregate supply due to QT.
Today, there is a conflict between the Fed’s desired interest rate regime and the Treasury’s desired liquidity conditions. For the past 18 months, the RRP has grown dramatically, first absorbing excess QE and later acting to enforce the Fed’s interest rate hikes.
The Fed’s own data shows liquidity conditions in the Treasury market are as bad or worse as they were during the 2008 global financial crisis and 2020 COVID panic.
To address this serious concern, the Treasury has begun exploring a new potential solution: Treasury Buybacks. For now, we don’t have firm details over when or if the Treasury will be conducting buybacks, but given the growing interest in this alternative, it’s important to consider now3.
At any point in time, the Treasury can directly influence market liquidity. It can use the $608 billion in cash currently sitting in the TGA to repurchase outstanding treasuries, adding dollars to the private market. But of course, this would leave less cash on hand to fund the government’s operating budget, and other things equal, would simply force the Treasury to issue more debt down the road.
In other words, a simple buyback can temporarily improve market liquidity, but outside of the timing gap between buybacks and issuance, there is no sustainable improvement to liquidity. This alternative is not compelling on its own.
But the math changes if the Treasury can buy long-term treasuries from the private market and fund these purchases with short-term cash sitting in the RRP. Under these assumptions, the RRP balance would shrink, the TGA would remain constant, and market liquidity would improve.
The only problem is that the Treasury can’t directly tap the RRP. Instead, it must issue short term Treasury Bills (T-bills) at an economically attractive rate and hope that Money Market Funds (MMFs) reallocate away from the RRP to earn the higher yield.
If successful, buybacks could reverse the dwindling liquidity conditions in the private markets, and the price of financial assets in the process. But the risk of unintended consequences remains high. Let’s consider both outcomes.
The Goldilocks Scenario
The “goldilocks” scenario is straightforward:
The Treasury buys back long-term treasuries, injecting cash into the private markets in the process
The Treasury issues an offsetting quantity of T-bills which are bought by MMFs, reducing their usage of the RRP
The net result would be similar to QE, though occurring within the balance sheet itself (and somewhat offset by the Fed’s headline QT). Liquidity would improve and risk assets would likely rise as the The Pool is refilled.
Such an outcome would be contrary to the Fed’s current monetary policy, but the Treasury is not beholden to the Fed’s inflation fighting mandate. Further, because it happens within the balance sheet and is a more a complex series of transactions, it will be easier for the Fed and Treasury to spin publicly, particularly if it solves the growing “financial stability” problem.
It would certainly be cheered by Wall Street and investors who have grown increasingly weary of the Fed’s tightening campaign.
One drawback to consider would be the impact on the yield curve. Goldilocks requires short-term rates to rise (to attract RRP dollars) at the same time that the Treasury puts downward pressure on long-term yields. The curve is already inverted today with the 3-month rate higher than the 10-year. Exacerbating this inversion puts more pressure on financial schemes that involve short-term borrowing and long-term lending.
The Treasury would also be reducing the weighted-average-maturity (WAM) of its debt profile, making its ongoing interest burden more sensitive to changes in policy rates.
But all things considered, the Treasury would happily accept these drawbacks if they could pull off the Goldilocks buyback.
Generally, when policymakers seek to improve financial market functioning, they lower short-term interest rates. To the contrary, rapidly rising short-term rates are generally a sign of acute stress.
The buyback scheme flips this dynamic on its head. In order to improve market liquidity, the Treasury would flood the market with T-bills in order to drive short-term interest rates up. Conceptually, the Treasury would be creating a huge new funding demand for short-term credit markets, under the assumption that there are ample funds available (trapped in the RRP).
For the buybacks to be effective, short-term rates in the private market need to rise above the RRP award rate, which today sits at 305bps and will likely increase to 380bps next week and 430 - 455bps by mid-December (depending on the Fed’s rate decisions). 1-month T-bills would need to rise significantly from their 3.33% yield today for the RRP re-allocation to occur. In the interim, you would not see the liquidity benefits, but rapidly rising short-term rates would create even more stress on financial market participants.
Second, the plan assumes that MMFs will freely and immediately reallocate from the RRP when presented with higher yielding opportunities. While this may prove to be the case, it is not a given. The RRP is the true risk-free asset. At equivalent yields, investors should prefer the RRP over T-Bills or private-sector repo because it has no duration, no volatility, and no counterparty risk.
We have very little experience to approximate exactly how much incremental yield MMFs require to compensate for the incremental risk4 of owning T-bills or engaging in private market repo, but such a spread exists and grows in times of stress.
In other words, the Treasury will rely on MMFs to step in to provide liquidity in the exact moment of rising financial uncertainty and strain.
Maybe they will. But maybe they will be content earning the Fed Funds rate directly from the RRP. After all, these funds have no duty to the Treasury or to support the broader markets wellbeing - they only have a responsibility to keep their investor’s money as safe as possible.
If MMFs don’t step in to absorb this new short-term funding demand, there is a possibility of chaos in funding markets, similar to the 2008 financial crisis, the September 2019 repo crisis and the 2020 COVID crash.
So far, many of our concerns around the RRP have proven accurate, and those risks are now at front of mind of the Fed and Treasury. Yet, the critical question remains unanswered. Will the RRP be a source of liquidity when the market needs it?
If it proceeds with the buyback plan assumed here, the Treasury will force the market to answer.
If the answer is yes and the RRP drains as expected, then the Fed’s tools work as intended and the market has a true $2.2 trillion liquidity buffer - more than enough to spur a risk rally. But if the RRP does not drain, then the possibility of a liquidity crisis in the near term will grow even greater.
How to position?
For rates, if the Treasury confirms a buyback plan, expect short-term rates to rise with increasing volatility and the possibility of tail events (i.e. a blowout in funding rates if things go poorly). Meanwhile, the yield curve should be expected to invert even further as the Treasury puts downward pressure on long-term yields.
For equities, it all depends on how effectively the Treasury can drain the RRP. The Goldilocks scenario would provide a powerful tailwind to financial assets despite the macroeconomic uncertainty. Meanwhile, unintended consequences could transform the bear market to crisis.
As always, thank you for reading. If you enjoy The Last Bear Standing, tell a friend! And please, let me know your thoughts in the comments - I respond to all of them.
If you are new to this topic, I would recommend reading Down the Drain which provides a more detailed explanation of these balance sheet dynamics.
Both as bank reserves and currency.
An important caveat. The assumptions used here are based on a buyback scheme that is most likely to address the liquidity problems at hand, and have been suggested by very smart commentators like Joseph Wang: https://fedguy.com/the-marginal-buyer.
Admittedly, these are small risks, but they must be priced. And MMFs are the most risk-adverse market participants.