US Treasury’s loan action of 1 tn dollars set to put banks under pressure

A $1tn US government borrowing drive is set to add to the strain on the country’s banking system as Washington returns to markets in the wake of the debt ceiling battle, traders and analysts say.

Following the resolution of this dispute – which had previously prevented the US from increasing borrowing – the Treasury Department will attempt to rebuild its cash balance, which last week hit its lowest level since 2017.

JPMorgan has estimated that Washington will need to borrow $1.1 billion in short-dated Treasury bills by the end of 2023, with $850 billion in net issuance of bills over the next four months.

A main worry from analysts was that the large volume of new issues would push up yields on government debt, sucking cash out of bank deposits.

“Everybody knows the flood is coming,”[ads1]; said Gennadiy Goldberg, a strategist at TD Securities. “Yields will increase because of this flood. T-bills will become even cheaper. And that will put pressure on the banks.”

He said he expected the biggest increase in Treasury bill issuance in history, except during crises such as the 2008 financial crisis and the 2020 pandemic. Analysts said the bills would have terms ranging from a few days to a year.

The Treasury Department issued guidance on Wednesday, saying it aims to return cash reserves to normal levels by September. JPMorgan said the announcement was roughly in line with overall estimates. The Treasury also said it would “closely monitor market conditions and adjust its issuance plans as necessary”.

Yields had already started to rise in anticipation of the increased supply, added Gregory Peters, chief investment officer at PGIM Fixed Income.

That shift adds to pressure on U.S. bank deposits, which have already fallen this year as rising interest rates and failures at regional lenders have sent customers scrambling for higher-yielding alternatives.

Further deposit flight and the rise in interest rates may in turn pressure banks to offer higher interest rates on savings accounts, which may be particularly costly for smaller lenders.

“The rise in yields could force banks to raise deposit rates,” Peters said.

Doug Spratley, head of the cash management team at T Rowe Price, agreed that the Treasury’s return to lending “could exacerbate stress that was already on the banking system”.

The supply shock comes as the Fed is already unwinding its bond holdings, unlike in the recent past, when it was a big buyer of government debt.

– We have a significant budget deficit. We still have quantitative tightening. If we also have a flood of treasury bill issues, we are likely to have turbulence in the treasury market in the months ahead, says Torsten Slok, chief economist at Apollo Global Management.

Bank customers have already moved heavily to money market funds that invest in corporate and government debt after the bank bankruptcies this spring.

Funds held in money market accounts hit a record $5.4 billion in May — up from $4.8 billion at the start of the year — according to data from the Investment Company Institute, an industry group.

But while money market funds are typically big buyers of T-bills, they are unlikely to buy up the entire supply, analysts said.

This is largely because money market funds already earn a generous risk-free return – currently 5.05 percent on an annual basis – on overnight funds that remain with the Fed. This is only slightly below the 5.2 per cent available on the comparable government rate, which carries more risk.

Currently, about $2.2 million a night is deposited into the Fed’s overnight reverse repurchase agreement facility (RRP), much of it from money market funds.

That cash could be redeployed to buy Treasury bills if they yielded significantly higher yields than the Fed’s facilities, analysts said. But the RRP rate moves with interest rates. So if investors expect the Fed to continue to tighten monetary policy, they are likely to keep their cash parked at the central bank overnight, rather than buying bills.

“While [money market funds] with RRP access can buy some T-bills on margin, we think this is likely to be small compared to other investor types [such as corporations, bond funds without access to the RRP facility and foreign buyers]Jay Barry, co-head of fixed income strategy at JPMorgan, wrote in a note.

Last week’s headline employment figures for May have added to the pressure by raising investors’ expectations that further rate hikes are coming – which could reduce appetite for government debt at current rates.