T-Bill Sales Are Draining the Market’s Extra Cash. It’s a Challenge for the Treasury.

Less and less cash is being parked in the Federal Reserve’s so-called overnight reverse repo facility. (Oliver Douliery/AFP/Getty Images)

Excess cash is getting sucked out of the financial machinery as the government increasingly turns to shorter-dated debt, or Treasury bills, to meet its borrowing needs. That is a risk for the market for ultrashort-term debt, including T-bills themselves.

The action centers on the Federal Reserve’s so-called overnight reverse repo facility, where market participants can safely park cash and receive a small amount of interest. Money-market funds from companies such as Vanguard, banks, and government-sponsored enterprises like Freddie Mac use the RRP, collecting annualized returns of 4.25%.

Back in December 2022, when usage was the highest on record, more than 100 counterparties had placed a total of $2.6 trillion in the RRP. But on Thursday, the figure was $28.82 billion, the lowest value since April 15, 2021. Only 14 institutions used the facility, also the lowest since April 2021. The five-day average balance now stands at $51.90 billion.

Created with Highcharts 9.0.1Drying UpDaily purchases of overnight reverse repurchases agreements:Source: Federal Reserve Bank of New York

Created with Highcharts 9.0.12021'22'23'24'2500.51.01.52.02.5$3.0 trillion

The reason for the decline is that since July, the Treasury Department has increased the amount of T-bills it issues to finance government spending. Because T-bills are also cash-like, safe, and can offer slightly more attractive rates for longer periods than overnight, money has flowed to them from the RRP facility. Money-market funds, the largest users of the overnight RRP, took about 66% of the $212 billion net T-bill issuance in July, according to Teresa Ho, J.P. Morgan’s head of U.S. short duration strategy.

In the first week of August, the Treasury offered a record high of $100 billion and $85 billion worth of four-week and 6-week bills. That debt likely was also purchased by money-market funds that shifted cash from the Fed facility. The 6-week bill had a rate 0.05 percentage points higher than that for reverse repos. Citi strategists expects the total held in the RRP to go near zero by month-end.

With that pool of cash drying up, the next logical source of money to buy T-bills is banks’ $3.32 trillion in reserves at the Fed. The problem there is that the market can’t afford a sharp decline in reserves. In 2019, when reserve balances sank, it threw sand in the gears of financial markets. The rate at which institutions borrow from one another overnight, called the Secured Overnight Financing Rate, rose dramatically, prompting the Fed to step in.

Citi sees bank reserves ending the year at $2.8 trillion. Fed Governor Christopher Waller sees around $2.7 trillion in reserves as a possibility, but it is difficult to know how high reserves should be. Most Fed officials and economists refrain from estimating the exact level of “ample” reserves.

“The next six weeks remain the key test for USD repo markets and we expect pressure in September,” Angelo Manolatos, macro strategist at Wells Fargo, told Barron’s by email. “There is likely to be over $260 billion of net T-bill issuance between now and the Mid-September corporate tax date.” Cash flows from short-term debt to the Treasury, reducing liquidity, when companies pay their taxes.

Funding markets have already become more volatile on certain days, such as the ends of quarters. More one-off disturbances where rates for overnight loans among institutions briefly rise a few dozen basis points wouldn’t constitute a disaster. But a sustained, rapid rise next month would mean something is broken, and the likelihood of that happening has increased with RRP, the Treasury market’s shock absorber, nearly depleted.

“Seeing those like [one-off] stresses in the system, it’s like a little bit of like a warning sign of, hey, there’s something happening in funding markets,” Alejandra Vazquez Plata, a senior rates research associate at Citi, told Barron’s. But only a sustained surge in overnight rates would be a real trouble sign, she said.

If an upswing lasts longer, she said, it would indicate bank reserves aren’t as high as they should be. It would also be a signal to the Treasury market that it needs to re-evaluate its T-bill issuance strategy. The lower the liquidity, the less money would be available to buy T-bills. Treasury would have to offer higher yields to attract buyers, in turn pushing up interest costs on the national debt in the short term.

In a research note, Vazquez pointed to a recent auction of a 1-year T-bill that encountered weak demand as an early sign of reduced liquidity in the market. “If you see auctions performing not as well…maybe the market is not as excited to take down these outsized T-bill auctions as they would have been otherwise,” Vazquez told Barron’s.

The Treasury Department didn’t immediately respond to a request for comment. It has repeatedly said that it “will carefully monitor market conditions and adjust its issuance plans as appropriate.” The Treasury’s current plan is to increase the size of its T-bill auctions in October.

J.P. Morgan’s Ho sees a “small” chance for a sudden shock to borrowing rates in the near term because money-market funds can keep increasing their assets under management and buy T-bills.

Overall, so far, demand for T-bills remains strong. In the third quarter of this year through Aug. 7, investors poured in $6.14 billion into exchange-traded funds that hold Treasury bills, nearly double the net inflow in the same period last year, Dow Jones Market Data Team says.

Stocks and corporate debt could be affected by trouble in the funding market, although how that would work isn’t clear, according to Steven Zeng, a strategist at Deutsche Bank. The market is already on edge with the S&P 500 trading at record highs, so the issue is worth watching.

Write to Karishma Vanjani at karishma.vanjani@dowjones.com.