Karen Shaw Petrou’s memorandum to Federal Financial Analytics clients on how short-term treasury fixes pose long-term structural, systemic risk and the development of new TBTF backstops.

TO: Federal Financial Analytics Clients

FROM: Karen Shaw Petrou

DATE: November 6, 2015

When questioned by Congress and the industry about Treasury-market illiquidity, the Treasury and FRB put a brave face on it. But, in the relative privacy of the Treasury Borrowing Advisory Committee last week, the guard came down. It turns out that Treasury knows full well how real the challenge is and how much new rules exacerbate it. Reflecting this, Treasury may well have to offer a new two-month note. The public record of this discussion also floats a new solution to market illiquidity above and beyond a new short-term bill: yet another government-blessed “facility.” What we’ve got here is Treasury redesigning T-bills to anticipate regulatory-stoked demand and the development of new TBTF backstops because market pricing and structure is now dictated by rules, not reality. Not exactly the end to TBTF for which we all so devoutly hope.

The reason for a new bond is that Treasury demand just keeps going up and up – who knew how many people have to have negative real rates of return? Demand for T-bills and bonds comes of course from exogenous factors like geopolitical and market risk, but Treasury readily acknowledged to this advisory committee that new U.S. rules are also a key driving force. Under the new SEC rules requiring floating NAVs for prime funds, many are quickly converting to “govvies” – that is, MMFs holding nothing but USG and agency paper and lots of it. The LCR and soon-to-be NSFR are also sparking Treasury demand, demand we think sure to grow larger as these rules combine with the leverage standards and the growth in govvies to limit ready access for both asset managers and banks to custody-bank cash deposits.

When Treasury presented the two-month bill idea, the committee apparently cheered, but pressed for even more on the short-term end – two weeks, anyone? How much of this will curtail demand for longer-dated Treasuries and thus distort the yield curve? How big a problem will this be for monetary-policy transmission, already struggling as it is with broken channels through the banking system? The meeting’s public record doesn’t say, but we surely need to know.

As Treasury also said, bills are a close substitute for repos, hiking demand as dealer-repo capacity shrinks. Treasury didn’t say why dealer-repo capacity is dwindling, but the capital and liquidity rules are of course a major contributing factor, as confirmed by a recent series of Federal Reserve Bank of New York blogs and various FedFin analyses.

Recognizing the need for a functioning repo market, some on the committee suggested a cleared-repo facility, although who would run it – the FRB? – and how it would address market illiquidity was not laid out.

The FRB has of course already become the biggest dog in the repo hunt with the reverse repo program (RRP), offering $250 billion at the end of the third quarter and even more from time to recent time. Importantly, the RRP has ballooned not to handle the FRB’s exit from accommodative monetary policy –its whole point – but rather as a new source of cash for MMFs and foreign banks. An OFR paper last week demonstrated the market role RRPs now play and concluded that its magnitude is such that a market-maker of last resort (MMLR) may well be required to ensure stability under non-bank liquidity stress.

Many Fed officials have already talked up this backstop facility, but the market-maker-of-last-resort construct isn’t official – Congress would be having even more fits about the FRB’s TBTF role if it were. Still, the MMLR has been talked up so much that many counterparties now count on it. They have to – the FRB’s lender-of-last-resort powers don’t work for non-banks, but non-banks are now such huge capital-market counterparties that something has to serve as a shock absorber.

Maybe a new repo-clearing facility could be constructed without a TBTF backstop, but any inference of a Fed or Treasury role will only double down on TBTF risk. Ad hoc decisions – a two-month T-bill, a new backstop – may solve near-term market problems, but they do so at great long-term risk.

With each “fix,” the Treasury market becomes ever more artificial in terms both of pricing and structure. As FRB Gov. Powell recently said, U.S. Treasury obligations need not only to be safe from a credit-risk perspective, but also sound if they are to remain the globe’s reserve currency. The more divorced it gets from market fundamentals, the greater the odds that Treasuries will take on new roles with most-uncertain impact that would then have to be fixed with still more TBTF support and FRB intervention. Rules may be right, but not if their cumulative impact is wrong-headed hikes in new-style TBTF financial institutions and markets.