When Federal Reserve Chairman Jerome Powell said this week that the central bank would expand its $3.7 trillion-sized balance sheet, he added the asset purchases would focus on short-term U.S. Treasury bills instead of longer dated debt.
It’s a crucial detail that helps the Fed telegraph to market participants that its contemplated bond-buying does not represent a return to the days of quantitative easing in the wake of the 2008 financial crisis.
The central bank is aiming to ease funding issues in the repo market, where hedge funds and banks borrow funds overnight, without triggering the perception that the Fed may be looking to inject monetary stimulus into the economy.
“Focusing purchases on the front end will also help make these purchases distinct from QE,” wrote Mark Cabana, head of short-term rates at Bank of America Merrill Lynch, on Wednesday.
Quantitative easing, or bond buying, after the financial crisis was effective at pushing down yields for long-term government bonds in the hopes that it would spill over into looser financial conditions across the economy. Buying up short-term bills only would thus underline that the central bank’s balance sheet increase is for “technical” reasons, and about greasing the wheels of short-term funding markets.
Since repo rates surged in September, traders and analysts have called for the central bank to restart the expansion of its balance sheet in order to boost the level of bank reserves to provide day-to-day liquidity in money markets.
“It’s the easiest lever to utilize to solve the situation,” said Aaron Stearns, co-head of AVM Solutions, a repo trader, in an interview with MarketWatch.
Stearns said the central bank’s attention on the short-end should help improve liquidity as repo agreements are considered a substitute to cash and Treasury bills, in that they all are forms of short-term funding.
But some say keeping asset purchases tilted towards short-term bills won’t deal with the underlying issues responsible for clogged-up funding markets.
Guy LeBas, chief fixed-income strategist for Janney Montgomery Scott, pointed out that the 24 primary dealers that directly trade with the Federal Reserve have too many long-term government bonds in their inventories. As the U.S. fiscal deficit swelled to about $1 trillion this year, dealers bought a lot of the issuance as part of their responsibilities to bid at U.S. Treasury auctions.
But regulatory rules mandating banks hold more reserves than their capital requirements have meant bigger institutions may be reluctant to parcel out their funds to others. So some dealers borrowed from repo markets instead of using their reserves to finance these purchases, contributing to the cash crunch in funding markets.
If the Fed were to take long-term bonds, instead of bills, off bank balance sheets it would free up valuable space in dealers’ inventories and allow dealers to provide liquidity as needed, said LeBas, in an interview.
U.S. Treasury positions for primary dealers stood at $206 billion in the week ending Sept. 25. This compares with a six-month average of $22.9 billion of Treasury bills, according to Federal Reserve data.
Likewise, Stearns doesn’t see the resumption of the balance sheet’s expansion as a “perfect solution.”
He said even if reserves do increase as a result of the central banks’ asset purchases, it’s not clear if they will distributed throughout the system to other participants in repo markets.
He said a standing repo facility that could be accessed by not just primary dealers but others like hedge funds, the ones most dependent on short-term funding markets, could help resolve the remaining kinks in the repo market.
Since Powell’s announcement, short-term Treasury yields have fallen. The 3-month Treasury bill TMUBMUSD03M, -1.81% fell to 1.67% on Thursday, from 1.70% at the end of Tuesday. The 10-year Treasury note yield TMUBMUSD10Y, +1.25% was last seen trading at 1.60%.