What happened to the “liquidity drain” bear case? Asked the curious market participants.
I’ve fielded any number of questions this month about the widely-circulated thesis that said a combination of factors including, but not limited to, a deluge of T-bill issuance post-debt ceiling deal, would likely sap liquidity and with it, risk assets’ joie de vivre.
The overarching narrative remains valid. The ECB, for example, confirmed last week they’ll cease APP reinvestments in July (i.e., accelerated QT). I assume TLTRO repayments are still a factor in the eurozone as well. At some point, the BoJ will pivot, although it still isn’t clear what that’ll entail. Student loan payments in the US are set to restart, which is a liquidity headwind too.
Of course, investors care most about the T-bill part of the narrative, and on that front, it appears that RRP balances are receding faster than some analysts expected. That, in turn, could mitigate reserve drain, leading to a more benign outcome. RRP demand dropped below $2 trillion late last week for the first time in more than a year.
The drop on June 15 (when the dip below $2 trillion occurred) was larger than keen observers anticipated. “We think these trends are being exaggerated to an extent by seasonal [factors],” JPMorgan’s Jay Barry wrote, while conceding that if usage continues to wane, “it could indicate that the replenishment of the TGA could be mainly drawn from reduced RRP demand rather than a reduction of reserves on the Fed’s balance sheet, in contrast to our baseline view.”
Suffice to say opinions vary widely, but it all ultimately hangs on how attractive bills are relative to RRP and whether money market funds are comfortable with maturity extension. “Once bills are sufficiently cheap, we project a Fed liquidity drain that draws 90% from ON RRP [and] 10% from reserves,” BofA’s Mark Cabana said last week. “These numbers imply a false sense of precision, but they reflect our expectation the marginal bill buyer will be a cash re-allocation out of ON RRP.”
“The supply thus far has been digested remarkably well,” Goldman’s Praveen Korapaty remarked, of Treasury’s cash rebuild. “Contrary to our expectations, bill yields (and some repo rates) have been settling above the RRP rate in many instances, incentivizing money funds to allocate away from the RRP facility to these higher yielding alternatives result[ing] in a sharp decline in RRP balances,” he added.
There’s some speculation that the drop in RRP might’ve been attributable to tax payments, but Korapaty went on to say that if you extrapolate from “the current faster rate of RRP balance depletion over reserves,” the result would be “a dramatically different reserve trajectory” compared to Goldman’s baseline. Although it’s early, Korapaty suggested that if things keep going the way they’re going, the system could stay in an ample reserves regime for quite a while yet.
JPMorgan’s Nikolaos Panigirtzoglou is skeptical. “To the extent relative cheapness was a factor” in attracting money funds to bills, “much of that has since disappeared, which should reduce this attractiveness,” he said, suggesting money fund demand could soon wane.
“We continue to think that the bulk of the TGA rebuild will come at the expense of reserves rather than ON RRP, meaning the rebuild adds to the liquidity drainage that will naturally occur through QT,” Panigirtzoglou wrote. “Even in the extreme case where the TGA rebuild would entirely come from ON RRP rather than reserves, this would still see a contraction of broad liquidity in the US of more than 4%.”
