(Bloomberg) — Treasury-bill yields have risen sharply as a wave of new issuance tests investor demand, posing a threat to the stability of overnight funding markets.
That dynamic showed up in the eight-week bill auction this week, with its record-low demand and yields at 4.05%, the highest in over a year — evidence of investor reluctance to pile into the growing supply of bills to fund the widening deficit and an uncertain path of Federal Reserve interest rates over the coming months.
That pressure, however, has yet to spill into the funding market that remain flush with cash, leaving it vulnerable to the growing stress evident in T-bill debt.
“Several competing forces are shaping money markets this month,” Barclays Plc strategist Samuel Earl wrote in a note to clients. “Depending on where one looks, the market appears caught between two very different narratives: signs of emerging funding pressure on one hand, and surprisingly subdued conditions on the other.”
Treasury has already issued nearly $100 billion of net T-bills through the first half of October, TreasuryDirect data show. Barclays estimates coming supply will exceed $320 billion over the next six weeks.
This has caused bill rates to widen relative to swaps on the Secured Overnight Financing Rate, a market-based metric considered the risk-free rate. Yet for most of October, SOFR has traded at or below the interest on reserve balances rate, or IORB, suggesting liquidity remains abundant despite growing pressure in the bill market.
Several forces are pulling markets in different directions. Money-market funds, the biggest buyers of T-bills, have seen inflows slow just as issuance accelerates. At the same time, portfolio managers have become “increasingly defensive,” preferring to buy shorter maturity debt due to uncertainty surrounding the trajectory of the Fed’s policy path, according to Earl.
The so-called duration positioning of taxable money funds has fallen to 35.3 days, down 3.4 days year-to-date and down 7.7 days from the peak seen in mid-April, according to Wells Fargo & Co., citing Crane Data LLC. The drop was most pronounced among Treasury funds, with the maturities for the institutional segment, the major holders of these funds, down nearly 10 days from end-April.
The shift is apparent in portfolio allocations, supporting demand for repo and floating-rate debt relative to fixed-rate Treasury bills. In fact, Federal Home Loan Bank debt issuance has been rising as FHLBs replace maturing debt and bank funding demand, according to Bank of America Corp. strategists. Issuance has been most concentrated in floating-rate notes, while supply in other bonds and discount notes has dropped.
Repo rates have nevertheless remained stable, which may be due to the structural decline in leverage demand this year as relative value and basis opportunities compressed, reducing the need for dealer-intermediated financing, according to Barclays.
Dealer repo books have also expanded following the relaxation of supplementary leverage ratio constraints, which Barclays estimates has allowed so-called G-SIBs, large financial institutions, to grow their repo and reverse repo balances by about $300 billion to $350 billion through September.
While the abundance of cash and investor appetite for the shortest-maturities has helped steady repo markets, it’s not without risks.
The Fed, for example, may decide to continue pausing its reserve management purchases for a prolonged period given the lack of apparent ructions in funding markets. The central bank this week said for the third straight month it won’t buy T-bills for RMPs.
That stance threatens to further exacerbate the already growing pressure in the T-bill market that could spill over into the overnight funding market.
“Continued slack in funding markets raises the risk that the Fed could remain on hold for longer, particularly if the reduction in balance sheet capacity into year end is more than offset by declining leverage demand,” Earl wrote.
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