MNI INTERVIEW: US Treasury Cash Rebuild To Force Early QT End

Massive new borrowing by the U.S. Treasury after Washington's debt ceiling resolution will likely cause a sharp drawdown of bank reserves, forcing an early end to the Fed's QT program as soon as the third quarter, former New York Fed staffer Dominique Dwor-Frecaut told MNI.

The Treasury has said it plans to gradually restore its cash balance to normal levels of about USD600 billion by September. To do so, it will likely issue more than USD1 trillion in bills through September, analysts estimate. With the Treasury General Account (TGA) at the Fed rising, reserve balances will likely fall to levels too low for comfort, risking the kind of volatility seen in late 2019 when the fed funds rate spiked way above the Fed's target range, Dwor-Frecaut told MNI's FedSpeak podcast.

"I doubt they can see the QT plan through to the end. I doubt it very much. In fact if the Treasury sticks to its plan of increasing the TGA to 600 billion by the end of September I think the Fed will probably have to do QE," she said.

"I don’t see the overnight reverse repo facility falling that much. So the Fed will probably have to stop QT earlier than it expects, possibly by the end of the third quarter in order to accommodate this permanent increase in the TGA."

NOT ENOUGH RRP RELEASED

The Fed is facing redemptions on its assets of roughly USD100 billion a month between QT and repayments of bank borrowing after the collapse of Silicon Valley Bank. On the liabilities side of its balance sheet are the TGA, bank reserves and the overnight RRP facility. Depending on whether bank depositors or money market funds invest in Treasury's new issuances, short-term markets could experience turbulence, said Dwor-Frecaut, now a strategist at Macro Hive.

"It depends on the reaction of the T-bill dealers to this massive issuance. If there’s a lot of demand out there to absorb newly issued T-bills then we won’t see much of a decline in the RRP. T-bills yields will remain low and the RRP more attractive," she said.

The RRP rate, set at 5 bps above the bottom of the fed funds rate target range, has been more favorable than the 1-month T-bill rate for the past year, and despite the Fed's initial expectations that QT would draw money market funds out of the RRP facility first, take-up of the overnight facility has been stubbornly high at over USD2 trillion for the past year and reserves have fallen far more than expected. (See MNI POLICY: Fed Resists Pressure To Retool QT, Reverse Repo)

The Fed has indicated it plans to stop balance sheet runoff when reserves are somewhat above the level it judges to be ample. A Deutsche Bank projections of reserve balances under different overnight RRP drainage assumptions saw reserves breaching the USD2.5 trillion "ample" level either between September and December, the latter being its baseline scenario, or never, if RRP balances drain quickly.

"The risk is not enough RRP money is released," Dwor-Frecaut said. "If that happens the Fed has a problem."

ISSUANCE SLOW DOWN

Dwor-Frecaut reckons there will be a further adjustment down of the end-June TGA target to head off potential market strains, saying the Fed and Treasury have incentives to work toward a common goal.

Treasury last week already revised lower its expected cash balance level by end-June to USD425 billion from the May 1 estimate of USD550 billion, promising to "carefully monitor market conditions and adjust its issuance plans as appropriate."

"My expectation is the TGA will be rebuilt in a much more gradual manner so as not to create a liquidity squeeze in the banking sector," she said.

HIGHER RATES

Aside from balance sheet policy, Dwor-Frecaut said she expects the Fed will need to raise interest rates quite a bit more to get inflation under control.

Growth has been resilient, fiscal policy loose and there is little sign of any unusual credit crunch. Various Taylor rules call for a peak rate of between 7% and 8%, meaning monetary policy remains too loose, she said. The Fed is expected to hold rates steady at a 5% to 5.25% range this week.

"Obviously this is a long-term view. The Fed is not ready to go there. But I think the persistence of inflation and likely reacceleration of inflation will force the Fed to reconsider its current stance, but this won’t happen for at least another six months."