The US Treasury market, supposed to be the supplier of the world’s risk-free assets, is facing a very educational 2021. As Mark Cabana, head of US rates strategy for BofA Securities, says: “There is going to be a train wreck at the front end of the [Treasury] curve next year. There is way too much cash chasing too little paper.”
Given what we know today about the US government’s likely spending over the next several months and its cash on hand, it is possible, even likely, that Treasury bill rates will be negative for a significant period of time. Other key interest rates, such as SOFR, the new lending benchmark, could well follow T-bills into negative territory.
Managing the effects of negative bill rates on banks and other market participants will require the ingenuity of the Federal Reserve and the new Treasury staff in applying their policy “toolbox”. All while avoiding any unforeseen consequences, such as we saw in March this year.
It would help everyone concerned if there were anything close to a political consensus on the path of federal spending and borrowing over the near future, never mind major policy changes. At the moment, the Treasury dealers and market participants are like an engine-room gang in a nuclear aircraft carrier, fighting over who occupies the bridge while there’s a slow-burning fire (the pandemic) in the crew’s quarters.
Overstatement? Consider this: under one of the laws governing Treasury issuance, the Treasury General Account (the US government’s current account) has a present balance of a bit more than $1.5tn. That is historically high. Under the budget law adopted in August 2019, which includes a debt ceiling limit, the TGA should be reduced to $133bn by August of next year.
Assuming, generously, that something like the current stimulus bill outline turns into executable law, that leaves the Treasury needing to allow somewhere between $500bn and $900bn of T-bills to mature in the first half of the year without being replaced by new issuance. Depending on the breaks.
That is a lot of cash that money market funds and others would need to redeploy. Oh, and Treasury securities provide another essential function, in that they can be pledged as collateral for variation margin calls at dealers or clearing houses if there’s any market volatility next year.
Credit Suisse strategist Zoltan Pozsar says: “Yes, a bill shortage would radiate out the curve, to the two-year and three-year, out to the belly. If on top of that there is a flight to quality, it would exacerbate that move. But I don’t think SOFR would go negative because the Fed could use their reverse repo facility.”
On one hand, the Treasury would have a very low, even negative, notional cost of funds. On the other, as the department’s Treasury Borrowing Advisory Committee wrote in November, “A substantial decline in T-bills supply is not desirable” and “stable value government money market funds face challenges should T-bill yields become negative for sustained periods”.
So, after arranging photo ops, Treasury secretary Janet Yellen will have to decide whether or not to hold off on running down bill issuance in the hope of negotiating a budget with Senate Republicans and her own liberal Democrats. Then there is that hard stop of a $133bn TGA on August 1.
Ah, but if the Democrats should win both Senate races on January 5, there might be a Democratic Senate majority in favour of lifting the budget caps and passing an even bigger stimulus package.
Life might become less problematic for the Fed’s Soma desk and the administration but then, the dealers worry, the volume of new issuance would put enormous strain on their balance sheets. For the largest banks, there is the added problem of compliance with the “G-SIB” regulations intended to limit their absolute size and consequent systemic risk concentration.
Really, it is enough to drive you to buy up canned goods, ammunition and iodine pills.
Or, you might agree with the other dealers and the regulators that it might be the time to set up a dedicated CCP, or clearing house, just for Treasuries. As one official who has been on the calls discussing the logistics of such a CCP said: “Eventually, it might have to be bailed out. The political cost of that bailout would, however, be lower than bailing out any banks.”