The US Treasury plans to borrow $1.007 trillion in the third quarter this year, a significant jump from the $554 billion estimated in April. This increase comes after resolving past debt ceiling issues, which allowed for higher spending. To manage its cash reserves, the Treasury is issuing more short-term securities, like T-bills. This strategy has cut its cash reserves to $300 billion, but they aim to boost this to $850 billion by the fourth quarter, projecting a borrowing of $590 billion then.

Financial Market Observations

Financial markets are closely watching if the US Treasury can keep issuing at consistent rates, even as the budget deficit grows. Due to recent legislative changes, the US fiscal deficit may reach $2.8 trillion over the next ten years. The Treasury will soon announce auction sizes and new issues of 3-year, 10-year notes, and 30-year bonds, with no changes expected to current plans. Continuing to issue short-term debt like T-bills shouldn’t disturb the bond market, as long as money markets can absorb the increase in T-bill offerings. However, this situation could change based on future economic and fiscal developments. With the Treasury planning to borrow over a trillion dollars in the third quarter, short-term interest rates might be under pressure. The influx of T-bills will quickly rebuild government cash accounts. Derivative strategies should focus on the expectation that short-term yields will rise as the market adjusts to this debt. It’s crucial to monitor the movement of cash out of the Federal Reserve’s reverse repo facility (RRP) and into these new securities. The RRP balance fell from over $2.1 trillion in May 2023 to under $450 billion by February 2024 during this adjustment. This reduction in liquidity means there’s less cash flowing in the financial system, which could tighten conditions.

Expectations And Risks

We expect this will cause the yield curve to steepen, with heavy issuance in short-term debt and long-term bond auctions remaining stable. This creates opportunities for trades that benefit from a growing gap between 2-year and 10-year yields. The emphasis on T-bills is a strategy to avoid upsetting the market for longer-term debt for now. However, there is a risk that the market may not be able to absorb all this debt as expected, especially since this adds to long-term deficit projections. It’s wise to prepare for potential volatility spikes in funding markets. Options on short-term rate futures could be a smart way to hedge against sudden tightening in financial conditions. This situation mirrors past events, notably the repo market crisis in the fourth quarter of 2019. At that time, a combination of high Treasury issuance and a shrinking Fed balance sheet triggered a sudden cash shortage, driving up overnight lending rates. We should be ready for a similar, though likely less severe, liquidity event in the weeks ahead. In the end, this liquidity withdrawal poses challenges for riskier assets like equities. As yields on safe, short-term government debt become more appealing, capital may shift away from the stock market. Thus, adopting a more cautious approach is advisable until the market fully absorbs this surge in issuance. Create your live VT Markets account and start trading now.

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