To The Moon

As of May 29th, President Joe Biden and House Speaker Kevin McCarthy have announced they have agreed in principle to raise the US debt ceiling and avert a default. For the market, reaching a debt ceiling agreement may mean the start of a new round of liquidity shocks, as it would allow for the issuance of new US Treasuries.

According to the US Department of Treasury forecast, approximately $1.46 trillion US Treasuries are expected to be issued in Q2 and Q3 of this year, which will inevitably absorb a significant portion of market funds.

Source: Tebon Securities

Why new issued Treasuries may cause a liquidity crisis?

Generally, when new Treasuries are issued, the balance of TGA on the liability side of Fed will be increased. Assuming the asset side remains unchanged, the issuance leads to the decrease in the net assets (Reserve Balance) of the Fed. This, in turn, affects market liquidity.

As shown in the graph below, in the post-pandemic era, there is a clear positive correlation between Fed's Reserve Balance and the trend of Nasdaq 100 Stock Index. $NASDAQ 100(NDX)$

Source: Bloomberg

Since reaching the debt ceiling at the end of January this year, the balance of its Treasury General Account (TGA) continues to decline as the US government has been unable to issue new Treasuries. Additionally, the tax revenue collected during the mid-April tax season was lower than in previous years. Currently, the TGA balance is less than $50 billion.

According to estimates from JPMorgan Chase, once the US government can resume issuing bonds, the balance of the Treasury Department's TGA account is expected to rise to $600-700 billion, returning to the levels seen in Q3 of 2022. Considering that Fed is still shrinking the balance sheet, a significant increase in the TGA balance could potentially lead to another liquidity crisis in the market.

Source: JPMorgan

How will new issued Treasuries affect market in three scenarios?

According to research by JPMorgan, the impact on market liquidity varies significantly depending on the type of institutions involved in absorbing the new Treasuries (non-bank private sector, banking system, or money market funds).

1. If the new issued Treasury is absorbed by non-bank private sector, it has the greatest impact on market liquidity.

In this scenario, non-bank institutions use their deposits on the liability side of banks to purchase the new Treasuries. This results in a simultaneous decrease in bank reserves on the asset side and reduction in Fed's Reserve Balance as the TGA rises significantly. At the same time, funds that could have been used to purchase other assets in the market are also reduced.

2. If the new issued Treasury is absorbed by banking system, the impact on market liquidity is moderate.

Banks adding the new Treasuries to their asset side can effectively offset the decline in reserves, thereby preventing a decline in deposits. However, given that bank deposits have been declining throughout this year, their capacity to absorb the new Treasury is limited.

3. If the new issued Treasury is absorbed by money market funds, it will not affect market liquidity.

Since Fed's interest rate hike last year, money market funds have been placing a significant portion of their funds in OverNight Reverse RePurchase (ON Repo) on the liability side of Fed, earning a decent risk-free return on a daily basis. Short-term US Treasuries with maturities of one year or less are also within the investment scope of money market funds.

Therefore, money market funds can absorb the new Treasury by reducing overnight repos. In this case, the liability side of the Federal Reserve (Repo) will decrease, offsetting the impact of the increase in the TGA account balance. Essentially, the funds that the Fed absorbs from the market are directly transferred to the US Treasury, so it does not have an impact on market liquidity.

Conclusion

JPMorgan Chase believes that the new Treasury supply is likely to be primarily absorbed by non-bank private sector and money market funds. The reduction in the liability side of Fed Repo balance will be less than the increase in the TGA account balance, thus potentially reducing Fed's Reserve Balance to some extent and impacting market liquidity.

We believe that given the ongoing trend of bank deposits flowing into US money market funds, there is still a significant fund inflow into US money market funds. This allows them to absorb the new Treasury without reducing overnight repo operations excessively. Additionally, the long-term new Treasury supply will primarily be absorbed by non-bank private sector, tightening market liquidity. However, Fed's Repo balance on the liability side is currently at a massive $2.61 trillion. Once it starts to be released, it can still serve as a backstop for market liquidity.

Source: Bloomberg

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