(Bloomberg) — Dollar-denominated funding markets are already facing myriad challenges that are distorting supply and demand, and these effects are only going to intensify as a return of the U.S. government’s statutory borrowing limit gets closer.
Rates for short-term dollar borrowing have been driven to zero and below, weighed down by Federal Reserve asset purchases, a drawdown of the U.S. Treasury’s mammoth cash pile and a shift from bank deposits to money-market funds. The reimposition at the end of July of the debt ceiling, which was suspended in 2019, is threatening to exacerbate this dynamic as its return also affects how much spare cash the Treasury can legally hold.
The reinstatement will force the Treasury to wind down its cash balance to levels near the previous suspension, or roughly $120 billion to $130 billion, from $924 billion now. That would push more cash into the market, while simultaneously yanking supply out of the market with bill paydowns.
While JPMorgan Securities strategists Teresa Ho, Alex Roever and Ryan Lessing estimate that gap between supply and demand is currently around $585 billion, there’s room for this to widen.
‘Too Much Cash’
“Anyway you slice it, there is too much cash looking for a home and not enough products to invest in and that’s what’s keeping everything tight,” said Gennadiy Goldberg, senior U.S. interest rates strategist at TD Securities. The debt ceiling “will just make Treasury’s headache even worse.”
The longer these idiosyncrasies persist, it’s going to force the U.S. central bank to intervene to maintain control over the short end — particularly its key policy target, the effective federal funds rate. The Fed seems to already be taking steps through changes to the mechanics of its facility for overnight reverse repurchase agreements.
Last month the Fed instructed the Federal Reserve Bank of New York to boost the size of the counterparty limit for the overnight reverse repo facility, or O/N RRP, to $80 billion from $30 billion, a move that could help prevent short-term rates from slipping even lower. The move has been well-received, with take-up quickly surging to the most in almost a year.
Lorie Logan, executive vice president at the New York Fed, said in an April 8 speech that the bank could adjust the eligibility requirements for its daily operation to allow for broader participation from the money fund community.
Adjustments Ahead?
Policy makers still have the ability to tweak the Fed’s interest on excess reserves rate, the offered level on the O/N RRP, or both. In minutes from the March Federal Open Market Committee meeting, Chairman Jerome Powell noted the potential for downward pressure on money-market rates and suggested it “might be appropriate” to make adjustments at upcoming meetings or even between gatherings to ensure the fed funds rate remains “well within the target range.”
The recent FOMC minutes suggest the Fed recognizes that the overnight repo rate is a “more important operational parameter than the IOER at present,” Wrightson ICAP economist Lou Crandall wrote in a note to clients. Wrightson expects that any initial adjustment to the O/N RRP — and potentially IOER — would be 2 basis points, while the second choice is a 3 basis-point tweak.
The fact that the FOMC is “laying the groundwork so explicitly for a potential adjustment” reinforces the belief that the Fed will be quicker to respond to downward technical pressure on overnight rates than in the past, Crandall wrote.
JPMorgan strategists, who said in February the Fed wouldn’t have to make any adjustments to its tools until mid-year, now say policy makers could make a tweak sooner. They aren’t alone in such thinking.
“It’s certainly on the Fed’s radar that the pressure is building,” TD’s Goldberg said. “They want to make sure the levy at the lower bound of the target range is powerful enough to contain this flood of cash.”
(Updates to include recent take-up of tweaked Fed operations seventh paragraph.)
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