No one's indestructible No one's indestructible No one's indestructible

No one's indestructible

Redmond Wong

Chief China Strategist

Summary:  In the evolving landscape of the US Treasury market, the Federal Reserve grapples with issues such as capital constraints on primary dealers and mounting unrealised losses. Striking a balance amidst these challenges, while navigating shifting financial dynamics, presents critical considerations and potential courses of action.


In the wake of the unprecedented global pandemic, the US Treasury market, traditionally viewed as a bastion of stability, underwent a seismic shift. On 12 March 2020, the world of US Treasury securities suddenly found itself grappling with turmoil. Primary dealers, the lynchpins of the US Treasury market, were inundated with a deluge of Treasury sales. Consequently, bid-offer spreads widened significantly, making it increasingly challenging to determine fair prices for these securities. In response to this crisis, the Federal Reserve took extraordinary measures. It extended massive financing to dealers and initiated a substantial purchase of almost a trillion dollars' worth of Treasury securities within a mere three weeks.

The US Treasury's response: The buyback program

To avoid a recurrence of the chaos witnessed in March 2020 and another occasion in September 2022, when the UK Gilt market experienced yield spikes and liquidity issues, the US Treasury introduced a buyback program for 2024. The Bloomberg US Government Securities Liquidity Index, which measures market liquidity, remained elevated, reminiscent of the levels observed during the crises of March 2020 and September/October 2022 (Figure 1).

Figure 1. US Government Securities Index; Source: Bloomberg
Another indicator of the risk of a sudden shortage of market depth is the average daily turnover of the US Treasuries market as a percentage of the total outstanding quantity of US Treasuries. This percentage has dwindled from over 12% to its current state, hovering around 3% (Figure 2).
Figure 2. Average Daily Turnover as % of Treasury Securities Outstanding; Source: SIFMA & Saxo

The less-mentioned mandate: The Federal Reserve's role

While the Federal Reserve routinely communicates its dual mandates of achieving maximum employment and maintaining stable prices, it also plays a vital but less-publicised role as defined in Section 2A of the Federal Reserve Act. This mandate obligates the Fed to promote the goal of "moderate long-term interest rates".

Recent research conducted by Duffie et al. (2023) underscores the critical role played by capital constraints on primary dealers in shaping liquidity in the Treasury market. When these constraints surpass 40%, liquidity in the market begins to deteriorate. As this figure climbs from 40% to 80%, illiquidity becomes more than just an anomaly, exceeding what can be attributed to rising yield volatility alone. Duffie (2023) underscored the importance of the Fed being prepared to conduct asset purchases to uphold market functionality during his presentation at the 2023 Jackson Hole Economic Policy Symposium. Duffie's estimates (2023) reveal that the exponential growth in outstanding Treasuries has outpaced the expansion of primary dealers' capital by nearly fourfold from 2007 to 2022.

A huge cost of QE: Paying interests on reserves

The 1913 Federal Reserve Act aimed to provide an ‘elastic’ currency system, enabling seamless fund transfers between bank deposits and currency without affecting the money supply. According to Section 2A of the Federal Reserve Act, the Fed's mandate is to achieve three objectives using one policy tool: maintaining monetary and credit growth consistent with the economy's potential. Historically, this involved purchasing Treasuries primarily to bolster bank reserves during currency withdrawals. However, since 2008, quantitative easing has shifted the focus towards ample reserves and interest payments on reserves, culminating in the elimination of reserve requirements in 2020. For a more detailed analysis, please refer to this Saxo article.

The Federal Reserve's financial landscape

This leads to a pertinent question: Can the Federal Reserve continue to act without restraint when primary dealers confront these capital limitations? In the first half of 2023, the Fed reported interest income amounting to USD 88.4 billion but also incurred interest expenses of USD 141.8 billion. After accounting for USD 4.4 billion in operating expenses, the Fed recorded a staggering loss of USD 57.4 billion. The bulk of its interest-earning assets was composed of USD 5.5 trillion in Treasuries yielding at 1.96% and USD 2.7 trillion in mortgage-backed securities at 2.20%. Simultaneously, the Fed was paying approximately 4.9% on USD 3 trillion of bank reserve balances and 4.8% on USD 2.4 trillion of reverse repurchase agreements.

The Fed's capital balance stood at a mere USD 42.4 billion. The six-month loss could have entirely wiped out the Fed's capital. However, the Fed accounted for the cumulative loss differently, designating it as a deferred asset labelled "earnings remittance due to the Treasury". This deferred asset witnessed a remarkable surge, growing from USD 16.6 billion as of 31 December 2022, to USD 74.7 billion as of 30 June 2023, and an astonishing USD 100.1 billion by 13 September 2023.

Under its remittance policy, the Federal Reserve remits all net income to the US Treasury after covering expenses and allocating a 6% dividend to commercial banks which are members of one of the 12 district Federal Reserve Banks. If earnings fall short of covering these costs, no remittance is made until earnings exceed that deficit. The accumulated loss is recorded as an asset because it represents a reduction of future liabilities to the US Treasury.

The complex structure of the Federal Reserve

The commercial banks which are members of district Federal Reserve banks are legally required to contribute capital equal to 6% of their capital plus surplus, with 3% of it being paid upfront and the remaining 3% subject to calls by the Federal Reserve bank. In a scenario where a district Federal Reserve bank faces a capital shortfall, it has the authority to compel its member banks to pay the unpaid 3% and an additional 6% of their capital and surplus to address the deficiency. This is a risk that is often overlooked by investors in banks.

The unravelling portfolio: Unrealised losses

As of 30 June 2023, the Federal Reserve's System Open Market Account (SOMA) portfolio was saddled with an unrealised mark-to-market loss of USD 1.1 trillion. This loss occurred against the backdrop of 5-year and 10-year Treasury yields standing at 4.15% and 3.84%, respectively. Subsequently, these yields have risen to 4.46% and 4.3%. Notably, around 47% of the Fed's SOMA portfolio had maturities exceeding five years, implying that the mark-to-market loss could potentially surpass the initial estimate of USD 1.1 trillion. If long-term bond yields continue to surge due to Fed rate hikes or increased Treasury issuance, the Fed's unrealised mark-to-market loss could expand even further.

Incentives and outcomes: The Federal Reserve's dilemma

In the realm of financial decision-making, Charles Munger's timeless wisdom rings true: "Show me the incentive, and I will show you the outcome." Within the intricate interplay of the Federal Reserve's role in the Treasury market, a multitude of incentives drive their actions, each potentially steering us toward distinct outcomes.

One significant incentive revolves around the Fed's role in ensuring the proper functioning of the Treasury market. While the extent of this role may be debated, it's clear that when crises like the one in March 2020 emerge, the Fed will intervene.

Another factor on the Fed's radar is the imperative to prevent further accumulation of losses. Addressing the unrealised mark-to-market loss and restoring the health of the SOMA portfolio is of paramount importance. To achieve this, there is a distinct incentive to reduce short-term interest rates, a move that could bull-steepen the yield curve, potentially exerting a profound influence on the market.

Potential courses of action

Amid this dynamic environment, the likelihood of lower short-term interest rates in the US is significant. Positioning for a bull steepening, consider going long on the front end to the belly of the Treasury curve.

Additionally, another potential course of action for the Federal Reserve is to cease paying interest on reserves. This shift could translate into billions of dollars in interest cost savings. However, this action must be weighed alongside the idea of reinstating minimum reserve requirements on banks. Reestablishing non-zero reserve requirements would become necessary to regain control over the overnight Fed Funds Rate. Such a move would signify a significant departure from the current approach and a return to the pre-2008 regime when the Fed managed interbank liquidity by influencing the availability of excess reserves through open market operations in the form of repos and reverse repos.

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