Bonus Clouded Judgement 6.5.23 - Upcoming Liquidity Crunch?

Jun 05, 2023

Quick Caveat - I’m no macro expert, but had fun putting together this post. Very open to feedback!

Liquidity

Liquidity drives markets, and is a term we’ve all heard many times over the last few years. When liquidity pours in, markets generally go up (as it did during the onset of the pandemic). And when liquidity is sucked out, markets fall. Given the recent debt ceiling deal, and its implications on upcoming liquidity in the markets, I wanted to write up a quick primer on what we could see in the weeks / months ahead with respect to liquidity. TLDR - the recent debt ceiling deal may actually pose a drain on liquidity (in addition to ongoing QT) as the government sells T Bills to refill the Treasury General Account (this starts today!). Total magnitude of sales could reach $1T+ by the end of the year

Treasury General Account balance is near zero - and a new debt ceiling deal will see a wave of bill sales to replenish it

But first - let’s level set on some key topics: Monetary Policy, Fiscal Policy and QE / QT and the Treasury General Account (TGA)

Monetary Policy

Monetary policy is the process by which a country's central bank or monetary authority manages the supply of money in the economy to achieve specific goals. These goals often include: keeping inflation sustainable (ie prices stable), maintaining sustainable levels of employment (ie low unemployment), and moderating long term interest rates.

In the U.S., monetary policy is conducted by the Federal Reserve. The central bank has several tools at its disposal to implement monetary policy. Open Market Operations: This involves buying and selling government securities to influence the amount of money in the banking system. For example, when the central bank buys government securities, it pays with money that it essentially creates, increasing the amount of money in the banking system.

Discount Rate: This is the interest rate charged to commercial banks for loans received from the central bank. By raising or lowering the discount rate, the central bank can influence the borrowing costs of banks, which eventually affect the interest rates offered to their customers.
Reserve Requirements: These are regulations on the minimum amount of reserves that banks must hold against deposits. Changing reserve requirements can affect the amount of money banks have available to lend.

Fiscal Policy

Fiscal policy involves the use of government revenue collection (taxation) and expenditure (spending) to influence a country's economy. It's primarily an instrument of the government, typically managed by the finance ministry or treasury department. The two main components of fiscal policy are taxes and spending. Taxes are straightforward. Government spending takes many forms, including investment in infrastructure, provision of social services, and transfer payments like social security and unemployment benefits. Increasing government spending can stimulate economic activity by injecting more money into the economy, providing jobs, and increasing demand for goods and services. Decreasing spending can have the opposite effect.

Quantitative Easing (QE)

Quantitative Easing (QE) is a monetary policy tool used by central banks to inject money into the economy to stimulate economic activity. Here's a simplified description of how QE works:

Buying Financial Assets: The central bank, like the Federal Reserve in the U.S., creates new money digitally. It then uses this new money to buy financial assets, typically government bonds or mortgage backed securities, from banks and other financial institutions. Buying of assets injects money into the economy (banks) which leads to:
Increasing Money Supply: By buying these assets, the central bank increases the amount of money in the banking system. This process adds new reserves to the banks' accounts at the central bank, essentially increasing the amount of money banks have available to lend.
Lowering Interest Rates: With more money available to lend, the increased supply tends to lower the interest rates that banks charge for loans. Lower interest rates can stimulate economic activity by making it cheaper for businesses and consumers to borrow money for everything from expanding a business to buying a home.
Encouraging Spending and Investment: The goal of QE is to encourage more spending and investment in the economy. By making borrowing cheaper and injecting more money into the economy, QE can stimulate economic growth.

In essence, QE is a way for central banks to encourage lending, spending, and investment to boost economic activity, especially during economic downturns or periods of slow growth.

Quantitative Tightening (QT)

Quantitative Tightening (QT) is essentially the reverse of Quantitative Easing (QE). It's a type of monetary policy that central banks use to decrease the amount of money in the economy. This is typically done in an attempt to control inflation or normalize the monetary policy stance after a period of QE.

While QE involves a central bank purchasing assets (like government bonds) to inject money into the banking system and stimulate the economy, QT involves the central bank selling assets or allowing them to mature without reinvesting the proceeds, thereby reducing the money supply.

Here's how it works in simple terms:

Selling Assets: The central bank sells securities it has on its balance sheet to commercial banks or other financial institutions. The money used by these institutions to buy the securities is effectively removed from the economy, reducing the amount of money in circulation.
Allowing Assets to Mature: Another way central banks can carry out QT is by allowing the bonds they hold to mature and not reinvesting the proceeds. When a bond matures, the issuer repays the principal to the bondholder—in this case, the central bank. This repayment is not reinvested in new securities, which decreases the amount of money in the banking system.

Both methods effectively reduce the reserves that commercial banks hold at the central bank, which can lead to higher interest rates. This can reduce borrowing and spending and slow down economic activity.

It's important to note that QT is a relatively new concept in monetary policy, largely coming into discussion after the extensive QE programs that were launched in response to the 2008 financial crisis. Central banks tread carefully when implementing QT, as moving too fast could risk destabilizing the financial system or abruptly slowing economic growth.

Treasury General Account (TGA)

The Treasury General Account (TGA) is essentially the checking account of the U.S. Federal Government. It is managed by the U.S. Department of the Treasury and is held at the Federal Reserve. The balance of the TGA goes up when the Treasury collects taxes or issues debt, and it goes down when the government spends money.

Just like a checking account that you or I might have at a bank, the TGA is used for the U.S. government's general daily operations. When taxes are collected from individuals and businesses, those funds are deposited into the TGA. Likewise, when the Treasury sells government bonds to raise funds, the money it receives from those sales is also deposited into the TGA.

When the government needs to spend money—to pay salaries of government employees, to fund government programs, to pay interest on the national debt, etc.—it withdraws funds from the TGA.

The balance of the TGA can fluctuate significantly based on the timing of the government's inflows (tax receipts, debt issuance) and outflows (government spending). The Treasury Department manages this balance to ensure that it has sufficient funds to meet the government's obligations.

Recap of 2020 to 2022

Ok - now that we’ve got the definitions out of the way let’s dig in. The Covid-19 pandemic led to an extraordinary use of fiscal and monetary policy tools around the globe to support economies and help individuals and businesses affected by the crisis.

Here are some key elements of fiscal policy response to the pandemic:

Direct Payments to Individuals: The CARES Act, signed into law in March 2020, included Economic Impact Payments (also known as stimulus checks) to individuals. These were direct cash payments to Americans below certain income thresholds to help offset the financial impact of the pandemic.
Expanded Unemployment Benefits: The CARES Act also expanded unemployment insurance, providing an extra $600 per week on top of state-level benefits and extending eligibility to workers who were not traditionally covered, such as freelancers and gig workers.
Paycheck Protection Program (PPP): This program provided forgivable loans to small businesses to pay their employees during the COVID-19 crisis. The intent was to help businesses keep their workers on the payroll and thus mitigate the rise in unemployment.
Tax Deferrals and Credits: Various measures allowed individuals and businesses to defer tax payments to future dates. The CARES Act also introduced a refundable payroll tax credit to encourage businesses to keep workers on their payrolls during the crisis.
Increased Funding for Health and Social Services: There was also significant additional funding for healthcare services, testing, and vaccine development, as well as for other social services to support those impacted by the pandemic.

Here are some of the key monetary policy actions taken by the Fed in response to the pandemic:

Lowering Interest Rates: In March 2020, the Fed cut its benchmark interest rate, the federal funds rate, to near zero. This was intended to lower borrowing costs and encourage businesses and consumers to spend and invest.
Quantitative Easing (QE): The Fed also significantly expanded its asset purchasing program, buying large quantities of government bonds and other securities to inject money into the economy and keep long-term interest rates low.
Lending to Financial Institutions: The Fed reactivated its discount window, encouraging banks to borrow money at low interest rates. This was aimed at ensuring that banks had sufficient liquidity to meet increased demand for withdrawals and loans from their customers.
Establishment of Special Lending Facilities: The Fed set up a series of emergency lending facilities to support the flow of credit to different parts of the economy. These included facilities to buy corporate bonds, support money market funds, and lend to small and medium-sized businesses.
Support for Commercial Paper and Money Markets: The Fed established facilities to support the flow of credit through commercial paper markets and to provide loans to financial institutions secured by high-quality assets purchased from money market mutual funds.

In summary - The Covid-19 pandemic led to an extraordinary use of fiscal and monetary policy tools around the globe to support economies and help individuals and businesses affected by the crisis. All of which greatly increased LIQUIDITY in the markets.

But then things shifted. Inflation skyrocketed higher and the effects of the pandemic started to ware off. In response, the government reversed a lot of the monetary and fiscal policy set up at the onset of the pandemic. The Fed started raising rates and stopped QE (and recently started QT). We more recently saw the end of the student debt forgiveness programs. All of this to say - the massive increase in liquidity that drove markets into the stratosphere during the pandemic completely reversed. Liquidity was being REMOVED from markets. The effects on equity markets has been quite clear.

So that brings us to today. As I’m sure many have read, the government recently ran up against its debt limit. Simply put, the government could not issue debt to fund operations. The implication of this was the only way to fund operations was to draw down money from the Treasury General Account (TGA), which I described above (you’ll see in the first graphic how low the balance got). This is where the nuance comes in. As I mentioned, we’ve moved past a time of low rates and QE to higher rates and QT. The former has been felt more than the latter. However - as the government looks to REMOVE liquidity from markets through QT, it was simultaneously ADDING liquidity to markets by drawing down the TGA balance (because they couldn’t issue debt).

When the Treasury spends money from the TGA, that money is transferred to the accounts of whoever is receiving the government spending. This could be individuals receiving social security, government employees getting paid their salaries, contractors supplying goods or services to the government, or anyone else the government is paying. These recipients typically hold their accounts at commercial banks.

So, when the TGA balance goes down, the reserve balances of commercial banks at the Federal Reserve go up. This is because when the Treasury pays individuals or businesses, funds are transferred from the TGA to commercial banks, where recipients have their accounts. Therefore, drawing down on the TGA effectively increases the amount of money (or "liquidity") in the banking system. When banking reserves go up, banks have more “firepower” to issue loans (which then incentives more spending). Higher banking reserves also typically put a downward pressure on interest rates (more supply = rates go down)

Quick summary of what I’ve described so far - some of the liquidity constraints introduced by QT and higher rates were being offset by liquidity added to markets through drawing down the TGA.

This brings us to today - a debt deal has passed. Great news! However - this now means that the government can sell bills (raise additional debt) to raise the balance in the TGA (because it’s near zero, and they need money to fund operations!). And they’ll have to issue a significant amount of bills…It’s estimated the government may sell $1T+ in bills by the end of the year to re-fill the TGA. This could be a massive drain on liquidity in markets.

Above I described how decreasing the balance in the TGA (drawing it down) can increase liquidity in markets. The opposite is true - increasing the balance of the TGA can DECREASE liquidity in markets. Especially when we see a massive increase in issuance to refill the TGA like we will se over the remainder of the year. How does this happen? Banks use their reserves to buy the newly issued T Bills. As their reserves go down, they have less firepower to lend out (and the lower reserves put upward pressure on rates).

So what does this mean? We may be entering a period of QT plus a liquidity DRAIN from refilling the TGA. While we were more recently in QT, it was at least partially offset by liquidity coming from drawing down the TGA. That offset is going away…

This topic is very nuanced. There are ways where selling bills to refill the TGA actually has a net neutral effect on liquidity (the Fed can manage this). It depends on who buyers are (bank vs non-bank institutions, domestic vs international, etc), the timing of the government spending that follows the capital raise, and many other factors. I’ve read smart people take opposing viewpoints on this. Some argue the impending treasury bill sales will greatly drain liquidity, others argue there will be a net neutral effect (currently $2.2T of money market fund cash sitting in reverse repo at the Fed which can be used to offset bill sales)

Coming up with a point of view on whether the bill sales will have a net negative or neutral effect on liquidity goes past the depth of my own knowledge. I won’t pretend to be an expert on the topic. I do believe regardless that there will be more headwinds to liquidity leaving markets in the weeks / months ahead. I believe bill sales start today (Monday).

My goal here is to lay out the situation we find ourselves in today, with some higher level context. Hopefully it’s helpful! I’m very open to constructive criticism on what I got wrong, or others viewpoints on what happens with liquidity throughout the balance of the year. I’m learning on the fly as well

Clouded Judgement