How the Treasury is quietly pumping cash into markets

Federal Reserve officials have spent the winter telling conferences that quantitative tightening (QT) is running at its full cap of $95 billion a month. Wholesale funding markets have hardly noticed. Credit spreads have narrowed and equity multiples have risen, while money market yields have stayed orderly. The explanation sits down the road at the US Treasury. Hemmed in by the debt ceiling, the Treasury has been releasing hundreds of billions of dollars from its General Account into the financial system, and in doing so has cancelled out much of the Fed's shrinkage.

Three places for the money

Central bank balance sheets obey an accounting identity. The Fed's assets must equal its liabilities, and those liabilities sit mainly in three places: bank reserves, the overnight reverse repo facility (ON RRP) and the Treasury General Account (TGA).

The identity means QT has to show up somewhere. When a Treasury bond on the Fed's books matures and is not replaced, the Treasury pays the Fed from its own account and then borrows from the public to top that account back up. The buyers pay from their banks, so reserves fall, or from money market funds that pull cash out of the reverse repo facility. Which liability shrinks determines who feels the squeeze, and at the moment the TGA is doing the opposite of what QT requires.

How QT reached full speed

The Fed began shrinking its balance sheet in June last year, at half the current pace, and doubled the monthly cap to its present level in September. It did so after two years of pandemic purchases that had swollen its holdings to roughly $9 trillion. The central bank has described the runoff as something that should hum along in the background while interest rates do the real work, and it meets this week expecting to raise rates again, by a smaller step than in December.

Spending down the TGA

With the statutory debt limit blocking new borrowing, the Treasury has to pay for government spending out of the TGA, which held about $500 billion in early January.

When the Treasury pays federal employees, defence contractors and healthcare providers, the money lands in commercial bank accounts, swelling reserves and leaving institutions with more cash to deploy. In effect the Treasury has been running a quantitative easing programme of its own, adding liquidity at a monthly pace that almost exactly matches the Fed's runoff.

The effect on funding markets is subtle but real. Banks with more reserves are less eager to bid for deposits, dealers have more room to finance positions, and the cash that would otherwise have been drained finds its way into the assets that respond most to liquidity. That goes some way to explaining why lower-rated credit and speculative technology shares have led the rally since the new year, even as the Fed insists that policy will stay restrictive.

A precedent from 2021

This has happened before, in a gentler form. In early 2021 the Treasury decided to run down a cash balance that had swollen during the pandemic, and hundreds of billions of dollars flowed back into the banking system within months. Treasury bill yields fell to around zero, and so much cash piled into money market funds that usage of the Fed's reverse repo facility rose from almost nothing to well above a trillion dollars that summer. The episode showed how directly the Treasury's cash management can overwhelm the Fed's intentions for short-term markets.

The cash runs out by summer

None of this will last. Each dollar drawn from the TGA brings the government closer to the "X-date" when its cash runs out, so the injection will probably stop abruptly by summer.

Janet Yellen, the Treasury secretary, has told Congress that her extraordinary measures should last until at least early June. The exact date depends on tax receipts, especially the April filing season, which can pull the deadline forward or push it back by weeks. Either way the runway is short, and the House of Representatives, now narrowly controlled by Republicans seeking spending cuts, has shown little appetite for a quick deal. Once the ceiling is lifted, the Treasury will run the process in reverse, pulling hundreds of billions out of bank accounts to rebuild its balance while the Fed carries on shrinking its own.

Why the buffer may not save markets

The best counterargument is that the reverse repo facility, which still holds more than $2 trillion, will absorb the shock. If money market funds buy the flood of new bills with cash they now park at the Fed, bank reserves need not fall much at all. That is plausible, and it is the main reason the refill need not produce a funding crisis like the repo spike of September 2019. But money funds will move only if bills pay more than the Fed does, which means higher short-term yields, and every bill bought by a bank, a company or a foreign investor out of deposits still drains reserves.

The market rally also has other supports. Inflation has fallen from its peak last June, China has reopened and energy prices in Europe have dropped, and these would lift risk assets whatever the Treasury did. The liquidity story matters most at the margin, for the assets that had run hardest on the least fundamental news. It is those assets that are most exposed when the Treasury's cash flows reverse.

The indicators to watch are published daily and weekly. The Treasury's daily statement shows the TGA balance, the New York Fed reports reverse repo usage every afternoon, and the Fed's weekly balance-sheet release shows bank reserves. A falling TGA alongside rising reserves means the Treasury is still offsetting QT, and the moment the TGA starts climbing after a deal the offset turns into a drain.

Today's easy funding conditions rest on the Treasury's dwindling cash. When the Treasury starts refilling its account, probably in the summer, wholesale markets will feel the full weight of QT for the first time. The combination of the Fed's runoff and the Treasury's rebuild could remove liquidity at roughly twice the pace markets have grown used to, and credit spreads and speculative equities are likely to give back much of their winter gains in the months that follow a deal.