The Treasury refills its account, and markets pay

The US Treasury is rebuilding its operating balance towards $600 billion, after running the Treasury General Account down to almost nothing to avoid breaching the debt ceiling. The pipes of the financial system are about to be pressure-tested. How the cash drain works is simple. Its effects on markets are less even, because someone has to give up central bank cash to hold the new short-term government debt.

From signature to supply

President Biden signed the Fiscal Responsibility Act on 3 June, suspending the borrowing limit and ending more than four months of extraordinary measures. The Treasury had kept net bill issuance down since January, when the government first hit the ceiling, so the market is short of the paper that money funds and corporate treasurers normally hold. That shortage now reverses. A wave of bill auctions over the coming weeks will do two jobs at once: replace the bills that were allowed to run off and build a cash buffer large enough to cover about a week of government outflows.

Reverse repo or deposits

Bond traders want to know whether the money will come out of the Fed's Overnight Reverse Repo (ON RRP) facility or out of commercial bank deposits. If money market funds move cash out of the RRP to earn the attractive yields on bills, bank reserves will hardly fall. If company treasurers and institutional investors pay for their bills by withdrawing deposits, reserves will shrink quickly. Banks would then have less spare liquidity and would once again have to compete harder for deposits.

The accounting shows why the source matters. The Treasury's account, the reverse repo facility and bank reserves are all liabilities of the Fed, so money moving between them changes the mix without changing the total, before quantitative tightening is counted. When a money fund pays for a bill with cash from the facility, one Fed liability falls and the Treasury's account rises, leaving reserves untouched. When a company pays from its bank account, the bank's reserves at the Fed are debited instead, and the banking system ends the day with less cash and fewer deposits.

The split depends on price. The ON RRP pays 5.05 per cent, with no credit risk and no need to manage maturities, and it holds more than $2 trillion, mostly from government money market funds. A fund manager will swap that for a bill only if the bill yields more, so the Treasury must sell its paper at rates above the facility's. The bigger that premium, the faster money leaves the facility and the less the drain touches bank reserves. The Treasury, in other words, can buy a softer landing for the banks, but only by paying more to borrow.

Banks are already paying up

Deposits are the part of the system with the least slack. Banks have lost deposits for more than a year as savers moved cash into money market funds and Treasury bills that pay far more than a current account. The failures of Silicon Valley Bank, Signature Bank and First Republic this spring pushed smaller lenders to raise deposit rates and borrow from the Fed's emergency facilities and the Federal Home Loan Banks. A bill that yields more than the reverse repo rate is a still better alternative to a bank deposit, so the refill hands savers another reason to move.

The Fed's own balance-sheet run-off adds to the strain. Quantitative tightening removes up to $95 billion a month of securities, and those dollars also come out of reserves or the reverse repo pool. In 2019 a similar combination of run-off and a cash rebuild by the Treasury left reserves thinner than anyone had judged, and overnight repo rates spiked in mid-September until the Fed stepped in. That episode led, two years later, to a standing repo facility through which banks can borrow against Treasuries, which should cap any spike this time.

Who gains from the refill

Money market funds are the clearest winners. They get a fresh supply of the short-dated paper their rules favour, at yields above what the Fed pays, and savers leaving banks will keep feeding them. Corporate treasurers gain another high-yielding home for spare cash. The Treasury pays for all this through higher bill rates, a cost that lands on taxpayers. The losers are banks that rely on deposits from large, rate-sensitive customers, and the regional lenders that were already paying up to keep them.

The case for calm

The optimistic reading deserves a fair hearing. The reverse repo facility holds far more than the Treasury needs to raise, so there is plenty of idle cash to absorb the bills before reserves are touched at all. Reserves also remain well above the levels that proved too thin in 2019. The previous rebuild, after the ceiling was raised in December 2021, passed with barely a ripple, although the Fed was then still buying bonds and flooding the system with reserves. The difference this time is that the Fed is shrinking its balance sheet while banks compete for deposits, so the cushion is large but no longer growing.

Signs to watch

The weekly H.4.1 release, published each Thursday, shows the Treasury's account, the reverse repo balance and reserves side by side. Mid-June brings quarterly corporate tax payments into the Treasury's account at the same time as heavy bill settlement, and the Fed meets on 13-14 June. If reverse repo balances fall roughly one for one with the rise in the Treasury's cash, the refill will have passed through the plumbing without much fuss. If reserves fall instead, regional banks will feel it in higher funding costs within weeks.

Refilling the Treasury's account will take hundreds of billions of dollars of liquidity out of circulation over the next few months. If the money comes out of deposits, banks will bear most of the cost of Washington's new cushion, and smaller lenders will show it in their second-quarter results through higher deposit costs and thinner margins.