How shrinking cash holdings at the Fed can improve liquidity in the $26 trillion Treasury market

By Joy Wiltermuth

Overnight demand falls to $834 billion on Tuesday from a pandemic peak of nearly $2.6 trillion

A popular pandemic spot for banks, money market funds and financial institutions to park cash at the Federal Reserve overnight could boost Treasury market liquidity.

A year ago, use of the Fed's popular overnight reverse repo facility rose to a high of nearly $2.6 trillion, but it has since declined to about $834 billion as of Tuesday, about the lowest daily demand for more than two years.

The reduced use of the facility appears to reflect increased confidence that the Fed will complete its most aggressive rate-hiking cycle in decades. Next week, the central bank is expected to keep its key interest rate at a 22-year high and begin cutting rates sometime next year.

Lauren Goodwin, economist and portfolio strategist at New York Life Investments, said she believes falling demand for the asset could also be due to increasing market liquidity. Her team found that a surge in liquidity this fall helped bring the 10-year Treasury yield back from its peak of 5% in October.

The sharp rise in the benchmark 10-year Treasury yield in October triggered a correction in the S&P 500 index SPX and the Nasdaq Composite Index COMP, which were quickly exited as yields fell and both stock indicators fell at least 10% from their recent levels Lows rose.

Goodwin argued in a note to clients Tuesday that rising interest rates may also prompt financial institutions to shift funds from the Fed's reverse repo facility to the $26 trillion Treasury market, “effectively pumping liquidity into the economy.” “.

“This increase in liquidity facilitates a redistribution of risk and in this cycle we have observed a pattern where greater liquidity correlates with lower returns and vice versa.”

Related: As Treasury yields rise, the Fed's reverse repo facility shrinks to its lowest level in 1 1/2 years

The high demand for the Fed facility was seen as an aftershock of pandemic-era liquidity flooding financial markets. There are fears that the process of withdrawing liquidity from markets could create nasty shocks, including to stocks, bonds and other financial assets, that could threaten financial stability – which could then lead to further monetary easing from the Fed.

There have been concerns about the potential impact on markets if the Fed's reverse repo facility balance approaches zero.

Still, Goodwin said she expects the benchmark 10-year Treasury yield to remain at a floor of 3.5% to 3.75%, even in a recession scenario.

“A decline in liquidity in the Treasury market related to the bank financial crisis, as well as supply and demand issues at the long end of the curve, have placed some upward pressure on yields in our view,” she said.

Instead, she said she believes a “significant” slowdown in economic growth “beyond the mild recession we expect” will likely be needed to push the 10-year Treasury yield closer to 3.0%.

Related: The bond market signals that a rapid U.S. economic slowdown is not off the table

-Joy Wiltermuth

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05/23/12 1430ET

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