Liquidity risk emerging? The U.S. Treasury increases the issuance of short-term government bonds, funds withdraw from the Federal Reserve's reverse repurchase agreement tool

According to Zhitong Finance APP, as the U.S. Treasury increases the issuance of short-term government bonds to meet financing needs, new trends in market liquidity are emerging. A large amount of funds is flowing out of the Federal Reserve's overnight reverse repurchase agreement (RRP) tool and into the more attractive Treasury bill market. This change has raised concerns among market participants that if the cash "buffer pool" is depleted, it may lead to a repeat of the funding market tensions seen in 2019.

Data shows that the usage of RRP has significantly declined. In December 2022, the usage of this tool reached a historic record of $2.6 trillion, while as of this Thursday, only 14 institutions were using it, totaling $28.82 billion, marking a new low since April 2021; the five-day average has also dropped to $51.9 billion. In contrast, in July, the U.S. Treasury issued a net increase of $212 billion in Treasury bills, of which about two-thirds were taken up by money market funds. Teresa Ho, head of short-duration strategy at JP Morgan, pointed out that these funds are the largest users of RRP and are reallocating funds to higher-yielding short-term government bonds.

Earlier this month, the Treasury set a record by simultaneously issuing $100 billion in 4-week bills and $85 billion in 6-week bills, with the latter yielding 5 basis points higher than the overnight reverse repurchase rate. Citigroup strategists expect the RRP balance to approach zero by the end of this month.

Once RRP funds are exhausted, the next potential source of funds will be the $3.32 trillion in reserves held by banks at the Federal Reserve. However, the market cannot withstand a significant decline in reserves. In 2019, a sharp drop in reserve balances triggered turmoil in the repo market, causing the overnight financing rate (SOFR) to spike, prompting the Federal Reserve to intervene. Citigroup expects bank reserves to fall to $2.8 trillion by the end of this year, while Federal Reserve Governor Waller believes it could drop further to $2.7 trillion, but there is still no clear consensus on what constitutes a "sufficient" level.

Wells Fargo macro strategist Angelo Manolatos warned that the next six weeks will be a critical test for the dollar repo market, especially during the corporate tax payment period in mid-September, when there may be over $260 billion in net new Treasury bill supply, significantly increasing liquidity pressure. He noted that during special times such as quarter-end, overnight borrowing rates have already shown volatility, and if funding costs continue to rise sharply in September, it would indicate structural problems in the market.

Citigroup interest rate researcher Alejandra Vazquez Plata also stated that the recent weak demand for 1-year Treasury bill auctions is an early sign of weakening liquidity. If the Treasury continues to issue bonds on a large scale and investor interest declines, it may have to raise yields in the future to attract buyers, thereby increasing the government's short-term financing costs. The Treasury responded that it will "closely monitor market conditions and adjust issuance plans as appropriate," and plans to further increase the scale of Treasury bill auctions in October.

However, some viewpoints suggest that there will not be a severe shock in the market in the short term. JP Morgan's Ho believes that the asset size of money market funds can continue to expand, allowing them to absorb more short-term government bonds. Data shows that as of August 7, $6.14 billion has flowed into Treasury-related ETFs in the third quarter of this year, nearly double that of the same period last year, indicating that overall demand remains strong Deutsche Bank strategist Steven Zeng reminded that if the financing market continues to be under pressure, it may affect the U.S. stock and corporate bond markets. With the S&P 500 index still at a high level, this risk requires investors' vigilance