Get ready for a flood of Treasury bills

Negotiators in Washington are edging towards a last-minute deal that would suspend the debt ceiling until 2025, and money markets are preparing for the hangover. For five months the Treasury could not issue new debt, so Janet Yellen ran the Treasury General Account (TGA) down from $500 billion to almost nothing. That cash flowed into commercial bank reserves. Once the ceiling is lifted the flow reverses. The Treasury will have to rebuild its balance by selling a large wave of new bills, more than $1 trillion within ninety days on current projections. The plumbing of global finance is about to be tested.

A bill flood of this size has no recent parallel. Pulling $1 trillion of cash out of the financial system in a single quarter sets off an immediate scramble for wholesale funding.

How the account was drained

The Treasury's account at the Fed works like the government's current account. When the Treasury pays pensions, salaries and contractors, money leaves that account and lands in the bank accounts of the recipients, which raises the reserves banks hold at the Fed. Since the government reached its borrowing limit in January, it has been paying its bills partly by running this account down, and that has added liquidity to the banking system at the very moment the Fed was trying to withdraw it.

Rebuilding the account runs the process backwards. Investors pay for new bills out of bank deposits or money market fund balances, and the cash moves from the private sector into the Treasury's account at the Fed, where it no longer counts as bank reserves.

Who buys the bills

What matters most is where the money to buy the bills comes from. If money market funds move cash out of the Federal Reserve's $2 trillion Overnight Reverse Repo Facility (ON RRP) to buy bills yielding 5.3 per cent, bank reserves will barely change.

If the funds hold out for higher yields, the bills will be bought by banks, companies and institutional investors drawing down their bank deposits, and reserves will fall. They could drop by hundreds of billions, making worse the deposit flight and margin squeeze that set off the regional banking crisis in March.

The funds' choice turns on a simple comparison. The reverse repo facility currently pays 5.05 per cent, with no limit on how much a fund can place there and no risk. Bills must yield more than that to tempt the money out, so the first effect of the flood will be to push short-term Treasury yields up until the switch pays.

The 2019 warning

The last time reserves became scarce, the result was abrupt. In September 2019 a large corporate tax payment date coincided with the settlement of new Treasury debt, draining reserves in a single day, and overnight repo rates jumped far above the Fed's target range. The Fed had to lend into the market for the first time in a decade and then start buying bills to restore reserves.

The circumstances today are different in one important way: the reverse repo facility holds a huge pool of cash that did not exist in 2019. They are the same in another. The Fed is shrinking its balance sheet by up to $95 billion a month, and each dollar of quantitative tightening removes reserves just as the bill wave arrives.

Dearer money all round

A supply wave on this scale will also push up short-term borrowing costs across the economy. Primary dealers will have to set aside scarce balance sheet to hold billions of dollars of government paper. Bid-ask spreads will widen, and less capacity will be left for making markets in corporate credit and mortgages.

The losers are the institutions that depend on cheap short-term funding. Regional banks will lose deposits to higher-yielding bills and money funds just as they were beginning to stabilise. Companies that borrow in commercial paper will pay more, and leveraged investors funding positions in repo will see their costs rise. Money market funds are the natural winners, since they finally get a large supply of the short-dated paper they prefer.

The case for a smooth absorption

The strongest counterargument is that the reverse repo facility is a buffer designed for exactly this. Money market funds have parked about $2 trillion there because they lacked alternatives, and they will happily move it into bills once yields rise a little. If most of the issuance is absorbed that way, bank reserves may fall only modestly, and the Fed also has its Standing Repo Facility to cap any spike in funding rates.

That is the most likely path, and it limits the damage. It does not remove it. The switch happens only after bill yields rise enough to make it worthwhile, and the Treasury is likely to front-load issuance to rebuild its balance quickly. In the first weeks, before the funds adjust, banks and their depositors will be the marginal buyers.

The signals to watch are the size of weekly bill auctions after the deal, the daily balance in the reverse repo facility, weekly reserve figures from the Fed, and the gap between the secured overnight financing rate and the rate the Fed pays on reserves around the end of June. Settling the debt ceiling removes the risk of default and replaces it with a sharp drain on liquidity.

Politicians will call the deal the end of a crisis. For markets it means about $1 trillion of cash withdrawn over the summer, on top of the Fed's quantitative tightening, and the regional banks will probably feel it first.