“Ask April”: T-Bill Tempest

Portfolio Strategist William Goldthwait met with Cash Portfolio Manager April Borawski to discuss how the market will digest the coming Treasury Bill (T-Bill) supply and the opportunities that may present.

William Goldthwait (W): It’s been a while since we sat down with April Borawski, Cash Portfolio Manager at State Street Global Advisors. The last few weeks have been interesting!

April Borawski (A): Interesting is an understatement! I’m sure all are aware of the rollercoaster ride politicians took us on with the debt ceiling issue. Luckily, they were able to reach a bipartisan deal and prevent a default. The deal was a compromise, with spending reductions and caps on future budgets, and they made sure to protect important programs like Social Security and Medicare. But, hey, let’s not get too comfortable because we’ll be revisiting this topic again in January 2025.

W: And so what happens next?

A: Right after the deal was passed, the US Treasury wasted no time and started increasing T-Bill issuance. They even offered off-cycle new T-Bills (cash management bills) and bumped up the regular weekly T-Bill issuance across different maturities. The Treasury must rebuild the balance in its general account (~USD 600 bn) and increase T-Bill issuance as a percent of its overall debt profile. Overall we’re expecting around USD 1 trn in additional T-Bill issuance before the end of the year.

W: Where will the cash come from to buy this new T-Bill supply?

A: It could come from money market funds (MMFs) or it could come from bank reserves. It will depend on the yields of those T-Bills.

W: Can you elaborate?

A: The recent 3- and 6-month bill auctions had strong participation, with some of that demand coming from MMFs. Presently [as of June 12], the 3- to 6-month bills are trading at ~5.20% to ~5.33%. Those yields are basically pricing in another 25 bp rate hike from the US Federal Reserve (Fed) or maybe even more. Even the 1- and 2-month bills are trading at a slight discount to the overnight repo rates. These higher-term yields are enticing for MMFs as an alternative to doing overnight repos with dealers and with the Fed. Recall that over USD 2 trn of cash is still parked at the Fed’s Reverse Repurchase Program (RRP), double the anticipated increase in T-Bill issuance, and almost all of this cash comes from MMFs. So, if MMFs chose to invest in T-Bills, they would most likely reduce their holdings in the RRP (the Fed would be happy to see less reliance on the RRP.) But if money market funds don’t like the yields on T-Bills and choose to remain in overnight repos, then direct investors and the primary dealers will have to absorb this new supply, and the cash to pay for those purchases would come from bank deposits and reserves. This could put further pressure on banks, similar to what we saw in March.

W: So, if MMFs buy T-Bills, we should not see any strain on the banking system, but if direct investors and primary dealers are the buyers, we might see some strain. But it sounds like, so far, T-Bill yields are attractive for MMFs; yes?

A: Unfortunately, it’s never that simple. There are several factors involved. First, this increased issuance has pushed T-Bill yields higher, which is great for MMFs and we have participated. But those yields could go even higher and become even more attractive. We’re just at the beginning of a massive increase in issuance and, as the market digests this new supply, we will remain cautious. Second, Fed Funds futures, presently [as of June 12], are indicating about 80% chance of a 25 bp hike at the next two Federal Open Market Committee (FOMC) meetings, giving us good reason to stick with repo. Lastly, there’s still a lot of uncertainty when it comes to cash flows. With T-Bill yields offering such tempting returns, there’s a chance that investors might choose to invest their cash directly into those T-Bills. It’s clear that the term “entry points” is becoming more attractive and we need to be thoughtful about when and where we buy.

W: Anything else we should be thinking about?

A: With everything going on lately, it’s easy to forget about quantitative tightening (QT). But the Fed continues to reduce its balance sheet by allowing up to USD 60 bn of US Treasuries and up to USD 35 bn of mortgage debt to mature each month from its portfolio, which removes liquidity and reserves from the system. Money supply (M2) – that forgotten metric from the 1970s – is now making its way back into the narrative as the growth in M2 has turned negative. Expectations, for the most part, are that QT might remain in effect throughout this year, with a possible wind down in 2024.

W: Are there any tactical trades you are looking at?

A: Government agency discount notes haven’t been that attractive for 2023 maturities, there just isn’t much value there. Things start to get interesting by early next year, but they’re still not that competitive considering the potential for rate hikes and T-Bill issuance in the near term. Government Agency Secured Overnight Financing Rate (SOFR) floaters could be more compelling for two reasons. First, the continuous T-Bill issuance might put some upward pressure on the SOFR index. Second, with the Fed hinting at a possible pause in the rate hike cycle, shorter-term SOFR floaters could offer a way to get a yield pick-up compared to overnight repo rates without being too exposed to potential rate cuts by the Fed.

W: And lastly, what about credit?

A: Demand for the front-end remains strong, with spreads on both fixed and floating rates holding steady despite the increase in T-Bill issuance. Presently [as of June 12], levels are around 5.45% for 3-month fixed and SOFR +30 bp for floating, 5.65% for 6-month fixed and SOFR +40 bp for floating, 5.68% for 9-month fixed and SOFR +55 bp for floating, and 5.70% for 1-year fixed and SOFR +65 bp for floating. These fixed spreads are roughly 20–70 bp wider than comparable T-Bill levels. Investors are leaning more toward floating rates due to the uncertainty surrounding the Fed’s rate path, but fixed rates are starting to catch attention at these levels, especially if investors believe the Fed might take a pause and hold rates steady for some time. Moving forward, we anticipate that the continued bill issuance, potential volatility in Fed rates, and prime money market reform could widen spreads. Our strategy is to maintain a balanced liquidity profile while gradually diversifying our exposures to both fixed and floating rates in the 3- to 12-month maturity range.

So, as you can see, there’s a lot to consider in the current market landscape. It’s important to stay vigilant and carefully navigate the evolving conditions.