Four years ago, the nightmare reappeared! The Fed's rate cut is imminent, will US Treasury bonds face a liquidity crisis?

According to Zhitong Finance APP, the surge in US Treasury bond issuance over the past year has sparked a debate on Wall Street about whether there will be enough demand in the future to avoid disrupting the financing market. Since the beginning of 2023, the US Treasury Department has issued $22.3 trillion in Treasury bonds, recently increasing supply to fill the government deficit. So far, the market seems to have easily absorbed the issuance of Treasury bonds, as seen in the pricing of Treasury bonds compared to other risk-free rates, such as the pricing of overnight index swaps, which has remained relatively stable. However, some are concerned that the Federal Reserve's eventual rate cuts and balance sheet reduction - known as quantitative tightening, or QT - will put pressure on the financing market. Some fear that this pressure may even be similar to the market turmoil that forced central bank intervention four years ago. Torsten Slok believes that once the Federal Reserve starts cutting rates (possibly in September), the demand from households and money market funds may decrease, putting upward pressure on short-term rates. The Chief Economist at Apollo Global Management wrote in a report last week, "Increasing the amount of outstanding Treasury bonds while the Fed is doing QT increases the risk of unexpected events in the financing market, as we saw in the repo market in September 2019." Others on Wall Street disagree with this view. As the Federal Reserve raises rates to the highest levels in decades, investors are flocking to money markets for higher returns, with the latest data showing total assets of $6.14 trillion, just slightly below the record high set last week. They argue that these funds will remain ample. Mike Bird, Senior Portfolio Manager at Allspring Global Investments, said, "The idea that demand for short-term notes will decrease during the Fed's easing cycle is a bit overblown. As long as we focus on money funds, we will continue to be interested. This demand will not disappear." As the Federal Reserve gets closer to cutting rates, money funds are extending asset durations - buying longer-term Treasury bonds - to lock in higher yields after the rate cuts begin. This means that companies that have been directly purchasing US Treasury bonds will instead shift cash to funds to take advantage of the lagging yields, further enhancing interest in money funds. Teresa Ho, Head of US Short-Term Rates at JPMorgan, said, "In the past three rate-cut cycles, funds have not flowed out of money market funds unless the Fed goes further in the easing cycle, so funds will continue to flow in. At least the current 4% to 5% yield is still quite high." Since the Federal Reserve first raised interest rates in March 2022, around $1.33 trillion has flowed into U.S. money market funds, with over half coming from individual investors. Deborah Cunningham, Chief Investment Officer of Global Liquidity Markets at Federated Hermes, previously stated that assets under management could reach $7 trillion, especially as a significant portion of cash from institutional investors such as corporations has yet to be transferred. Furthermore, facing new requirements from the U.S. Securities and Exchange Commission (SEC), money market funds - already the largest buyers of Treasury securities - may become even larger buyers. The SEC's measures (scheduled to take effect in October) will impose mandatory liquidity fees on some funds during financial stress periods, thereby increasing the cost of withdrawing funds. This will boost demand for instruments like Treasury securities at the expense of higher-risk assets. On the supply side, with the debt ceiling set to be reinstated on January 1st next year, the market may face a reduction in bond issuance. In such a scenario, the U.S. Treasury will take steps to stay below the limit before exhausting its borrowing authority, including significantly reducing Treasury issuance. This could create an imbalance at the front end of the yield curve, similar to the period from 2021 to 2023, with cash exceeding the amount of investable assets available. Meanwhile, the U.S. Treasury will continue to issue Treasury securities to fund larger deficits. "The U.S. Treasury won't issue securities willy-nilly," said Bird of Allspring, "This is where they can get the most funding when they need it. They will ensure demand for the product."