1. THREAD: Series by @GeneralTheorist
*To catch a falling knife: US Treasuries and the Fed*
The continued US deficit in 2021 puts Treasuries in focus, with 10y yield already having moved about 80bps higher to 170bps, & a number of weak primary auctions in Q1. What’s going on?
*To catch a falling knife: US Treasuries and the Fed*
The continued US deficit in 2021 puts Treasuries in focus, with 10y yield already having moved about 80bps higher to 170bps, & a number of weak primary auctions in Q1. What’s going on?
2. In a series of Substack blogs, we attempt to frame the unique situation in the US this year. Post-GFC and last year, the US fiscal deficit was the natural counterpart to private sector surpluses.
3. In 2021, the Federal deficit remains high despite the acceleration in private consumption and investment on vaccines and lockdown ending. How to reconcile both sectors attempting to move into deficit?
4. We recall the Swedish macro tradition from the 1930s whereby ex post spending plans are reconciled through the monetary system even if ex ante plans do not mesh.
5. Today’s anticipated deficit plans will be reconciled through a combination of (i) a wider external deficit; (ii) higher corporate profits, wages and employment; (iii) greater tax revenues; (iv) rationing of supply; and (iv) #inflation .
6. Or, private disposable income will adjust higher so that domestic private saving remains the counterpart to the Federal deficit still. In this respect, 2021 will resemble 2020.
7. However, there are differences. In particular, the structure of financing could change dramatically.
8. In 2020, the government issued USD4.6 trillion in Treasury securities—of which USD4.3 trillion were marketable and USD2.5 trillion in Bills. The deficit was USD3.3 trillion, meaning increased debt allowed an increase in TGA deposits at the Fed of USD1.3 trillion.
9. So, the Treasury sterilized part of the Fed asset purchases last year, and the planned drawdown of TGA will part finance the deficit this year, adding to bank reserves and pressure on money markets.
10. Indeed, because of Fed purchases in 2020, despite the large deficit, net duration assets declined by USD0.7 trillion, while Fed reserves and T-bills outstanding increased USD3.8 trillion, the counterpart to the money supply growth. 
11.The Treasury’s funding plan in February—before the Biden Plan—foresaw a USD1.6 trillion deficit in H1 and signalled a USD1 trillion decline in T-bills by end-June alongside a USD1.2 trillion drawdown of TGA deposits.
12.As a result, net coupon issuance of USD1.4 trillion would be needed. Yet even with the Fed buying about USD20 billion Treasuries per week, net coupon securities to be absorbed by the private sector would still be about USD0.9 trillion by June.
13. The next Treasury funding plan update is scheduled only on 3 May, so further guidance remains about 4 weeks away. Still, given private spending plans and the reflation narrative, duration issuance at this time is indeed like asking markets to catch a falling knife.
14. To we note a number of financial plumbing issues. Earlier this month the Fed confirmed SLR relief applied to banks’ holdings of reserves & Treasuries will expire end-Mar 2021. SLR being ratio of their Tier 1 capital to on and off-balance sheet exposures (not risk weighted)
15.This matter is not completely resolved, however, since the Fed also invited public consultations on possible SLR modifications, suggesting relief on reserves remains possible looking ahead.
16.Still, despite the ending of relief, SLR will not be immediately binding as the 5 percent lower bound on G-SIBs is not binding. Hence expiry of the relief hardly impacted markets.
17.But even with SLR space, what really matters to banks is achieving a reasonable ROE for investors. Continued balance sheet expansion into low-risk but low-return assets (such as reserves at the Fed) is inconsistent with adding shareholder value.
18.And large banks are already applying greater charges and pushing away least desirable deposits, something that will likely accelerate as the Treasury further draws down TGA balance and Fed asset purchases continue.
19.But where will these deposits go? Some will migrate to smaller banks. But many will seek non-bank financial intermediaries, such as Money Market Funds (MMFs), as an outlet for their savings.
20.Yet with Treasury planning to roll off outstanding Bills in 2021, outlets for MMFs are shrinking. With cash flowing into MMFs and a growing shortage of money market instruments the yield on Treasury bills is being pushed to zero or beyond.
21.Presumably in anticipation of this challenge, the last FOMC meeting saw the Fed increase the counterparty limit on ON RRPs to USD80 billion per day. This is overnight reverse repos, an outlet for Fed reserves accessible by MMFs.
22.This becomes an outlet for growing Fed liquidity, taking the strain off the banking sector. And indeed, in recent weeks MMF total assets have begun to increase again, while ON RRP bids accepted by the Fed has increased to above USD100 billion once more.
23.This works for cash saving by the public. But what happens if Treasury plans to substantially increase both the weighted average maturity of government debt (as they suggested they would in February) are realised?
24.Among residents, households can hold claims directly on the government or via bond or pension funds. Alternatively, non-residents may look to take advantage of rising yields in the US.
25.If so, there will be a hand-off from rapid money supply growth in 2020 to the expansion of non-bank intermediaries in 2021, reminiscent of the Fed’s very early years when recycling of Liberty Bonds from bank balance sheets to the public was an objective.
26.This brings us full circle back to the financing of WW1, which is where our substack begins. In the early days of the Fed, extension of credit by banks to the government, by expanding the money supply, was seen as inflationary.
27.In issuing Liberty Bonds after WW1 directly to the public they hoped to affect a disintermediation, limiting the money supply to head off this inflationary threat.
28.The situation is very different today, of course. We have moved on from a simplistic quantity theory view of money & price level.
29. But banks are close to exhausting their willingness to absorb Treasuries & Fed reserves on purely profit grounds, & new government financing has to find expression instead through non-bank financial domestic intermediaries or non-residents.
30.But just as in the 1910s, financial plumbing & monetary-fiscal interactions remain crucial to policymakers & financial markets. Not out of fear of inflation, however. Rather simply to arrange the financial setup in a way that doesn’t create disruptive asset price volatility.
Part 1 of the Series: moneyinsideout.exantedata.com/p/to-catch-a-f…
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