Treasury’s Debt Deluge Is Finally Straining US Funding Markets

The Treasury’s barrage of bill issuance is starting to cause some cracks to appear in the US dollar funding space.

(Bloomberg) — The Treasury’s barrage of bill issuance is starting to cause some cracks to appear in the US dollar funding space. 

On days when US note and bond auctions settle, the rates on overnight repurchase agreements — those loans collateralized by Treasuries — have climbed as more securities enter the market, according to Bank of America Corp. strategists. And those rates are taking longer to come back down. That pressure is spilling into other areas like T-bills and bank credit, including commercial paper and certificates of deposit, further hampering liquidity conditions for financial institutions already struggling to retain deposits amid the highest US benchmark interest rates in 22 years.

“Funding markets are evolving to show clearer signs of modest upward funding pressure,” said strategists Mark Cabana and Katie Craig. “Money market cheapening is likely to build further and it may present a greater headwind to liquidity-strained banks.” 

The glut of cash after trillions of dollars were pumped into the system since the start of the Covid-19 pandemic has finally started draining as the Federal Reserve unwinds its balance sheet in a process called quantitative tightening. Further pressured by the stream of new government debt, BofA said ripples are starting to appear across the repo market and spilling over into bank credit.

With the spread between three-month financial commercial paper rates and overnight index swaps — a proxy for Fed expectations — widening of late, institutions are “aggressively” issuing CDs and other borrowings to offset deposit outflows, fund loan activity and prevent forced sales of securities portfolios, especially during the broader Treasury market selloff, Cabana and Craig wrote in a note Friday. This will only push banks’ costs of funding higher. 

In the bilateral sector — where cash providers lend to hedge funds — rates are trading well above the offering yield on the Federal Reserve’s overnight reverse repo facility, an indication of increased activity from levered accounts. That’s helping pull triparty — where a dealer is responsible for the transaction between lender and borrower — rates higher, according to Citigroup Inc. strategist Jason Williams. 

“We have warned structurally that the triparty discount was likely to evaporate this year – we think this is finally coming to fruition,” Williams wrote in a weekly note dated Oct. 6. “It did not make sense to us for non-RRP investors to accept such a discount to bilateral rates, given bilateral was trading well above RRP.” 

While there’s still nearly $1.3 trillion parked at the Fed’s so-called RRP facility keeping rates contained that cushion is evaporating with usage down by about $877 billion since June. If counterparties reallocate that cash, banks may start to demand higher repo rates to lend their excess reserves in the repo market, pulling the rest of the funding space with it, according to Citi’s Williams. 

Those pressures in the repo market are expected to drive up costs for bank liquidity, according to BofA. “Dealers & investors are likely increasingly long collateral and need help funding it,” according to Cabana and Craig. “This funding pressure will continue to build over time.”

Investors will get a glimpse of the landscape for banks’ funding when the sector begins to report its earnings for the third quarter on Friday.

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