The US Treasury Department made an announcement that came as a surprise to many market participants in which the estimated amount of new Treasury issuance was reduced by nearly one trillion dollars.
Below is the PDF press release containing the preliminary information about the updated borrowing schedule.
This eventuality was predictable based on an "overfunded" Treasury General Account, something discussed with subscribers to EPB Macro Research in December of last year in a note titled, "Unintended Consequences."
In that research note, we discussed the unintended consequences of excessive Quantitative Easing "QE" and the impact on short-term/money market interest rates.
We also covered what the potential impacts of this announcement would be on the bond market, and several steps the Federal Reserve and Treasury Department will eventually take to solve these new issues.
Below is a clip of the December research note.
Unintended Consequences
(Dec. 16, 2020)
The crisis in March of 2020 caused the Federal Reserve and the Treasury to ease policy in an unprecedented fashion. The lack of immediate inflationary pressure or disruption to currency funding markets fueled a narrative that the Federal Reserve could grow its balance sheet to double or triple or even more than its current size of slightly more than $7 trillion.
Unintended consequences always emerge from theories of grand design. In this note, we will explore how and why short-term interest rates have come under pressure, what the Federal Reserve can do to prevent short-term interest rates from falling below 0%, and why this may be important to the broader Treasury and currency market.
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To summarize, when reserves in the banking system grow far beyond what banks need for payment purposes, banks look to exchange reserves with another bank that may need more reserves and look to deploy new cash into securities or loans. Under new regulations since the 2008 financial crisis, banks can be penalized for growing their balance sheet, particularly when investing in risky securities or loans. As a result, Treasury bills, the most sought after and purest form of collateral in the global financial system are suitable replacements for reserves, particularly when the interest rates on Treasury bills exceed the interest rate paid on reserves.
We have already seen Treasury bills out to 12-months trade below the 0.10% earned on reserves at the Fed. There are currently about $5 trillion of Treasury bills outstanding. There are price indiscriminate buyers of Treasury bills between what the Federal Reserve owns and the $4 trillion across money market funds.
The Treasury department, expecting more stimulus, already raised a substantial amount of money that is sitting in the Treasury's checking account at the Federal Reserve, also known as the "TGA." If Congress agrees to a stimulus package that is less than the roughly $2 trillion already funded in the TGA, the Treasury may be in a position, based on debt ceiling rules, to "return" the money in the Treasury account back to the public in the form of canceled T-bill or T-note issuance.
The combination of trillions of dollars of money market funds, bank reserves that are expected to exceed $5 trillion, and the possibility of canceled T-bill auctions may force short-term interest rates deeply negative, forcing the Federal Reserve to defend the zero-lower-bound "ZLB."
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Negative interest rates across dollar funding markets could raise many potential problems and, optically, is not something the Federal Reserve is likely to let stand.
The Federal Reserve has virtually no control over long-term rates but has explicit control over short-term rates. The Federal Reserve will have to respond if they look to maintain control over the short-term interest rate policy.
Ironically, at a time when yield curve control is gaining ubiquitous coverage, the Fed may be forced to use some form of yield curve control to keep rates up, not down.
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In the days to follow, we will update this research note with the new information from the Treasury Department and discuss the implications for the Treasury market as well as the knock-on effects in the stock market and precious metals complex.
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