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Why Treasury Issuance and Quantitative Tightening Both Unlikely to Impact Markets

Why Treasury Issuance and Quantitative Tightening Both Unlikely to Impact Markets

Wednesday, July 19, 2023 ~ Many pundits have warned that heavy treasury issuance post debt ceiling crisis combined with ongoing Fed quantitative tightening would impact the money supply and the capital markets as capital is withdrawn from the system by these actions. But most investors do not appreciate that the primary way that the Fed impacts the money supply is through open market operations which can completely offset quantitative tightening or changes in Treasury cash deposits at the Fed.

The Fed started paying interest on reserves in 2008, which helps keep the Fed Funds rate within target but is not sufficient to maintain the target range in most markets. The New York Fed is continuously borrowing and lending in the repo market, to reduce or increase short term liquidity and keep rates within the specified range.

Few investors realize that the Fed had to conduct large reverse repo operations (borrowing money from banks to reduce liquidity) which began in the middle part of 2021 (just to keep the Fed Funds rate above zero). By the beginning of 2022 the Fed’s reverse repo stood at $2 Trillion and subsequently rose to a high of approximately $2.5 trillion in mid-2022 as the Fed tightened policy.

Since the debt ceiling agreement in late May 2023, where treasury cash deposited at the Fed was $40MM, reverse repo was $2.6T and bank reserves were at $3.25T, treasury cash has risen to $515MM, reverse repo declined to $2.15T and bank reserves were $3.17T.

Consequently, almost all of the increase in treasury issuance was absorbed through open market operations (reduction of reverse repo/Fed borrowings from the street). Going forward, if the Fed keeps rates relatively stable, reductions in the Fed’s reverse repo balance are likely to offset the roll off in the Fed’s balance sheet, and, consequently, should not materially affect liquidity in the capital markets.

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