Fed Balance-Sheet Runoff, Treasury Supply, and Funding Liquidity
Summary
This discussion explains how changes in Treasury issuance and bank reserve preferences can affect short-term funding markets. It connects a liquidity squeeze in the first half of 2018 to heavy Treasury bill issuance as the Treasury rebuilt cash balances after the debt-ceiling debate. Investors buying bills instead of corporate and bank commercial paper were described as one channel for wider Libor–Fed Funds spreads.
The answer then considers the less certain effects of Federal Reserve balance-sheet runoff. In principle, banks might replace excess reserves with Treasury bills and bonds, since both qualify as high-quality liquid assets. But if banks prefer reserves and are unwilling to treat Treasuries as equivalent, their continued reserve demand could put upward pressure on the Fed Funds rate. The discussion frames this as an uncertain possibility, not a settled outcome: it says the runoff scenario had not previously been observed and does not quantify the effects or establish a single cause for liquidity conditions.
Key ideas
- Heavy Treasury bill issuance can compete with corporate and bank commercial paper for investor funding.
- The resulting shift in demand was linked to wider Libor–Fed Funds spreads during the period discussed.
- Treasuries and excess reserves can both qualify as high-quality liquid assets, but banks may not view them as interchangeable.
- If banks continue to prefer reserves during balance-sheet runoff, Fed Funds rates may face upward pressure.
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# Reduction in banks excess reserves link to liquidity and funding # Reduction in banks excess reserves link to liquidity and funding I fail to understand how the reduction in bank excess reserves due to the Fed slowly reducing its balance sheet is linked to a squeeze to liquidity and funding. The Treasury will have to raise issuance to fund the Fed's portfolio run-off. This means that the private sector will have to absorb additional liquidity in the market. Is the reason why liquidity is being squeezed due the Treasury competing with funding demands? Banks will have to replenish reduction in excess reserves to maintain HQLA so there should be demand for increased Treasury supply... ## Answer by dm63 (score 2, accepted) https://quant.stackexchange.com/a/40794 Lots of questions here. The reason why there was a liquidity squeeze in H1 2018 was most probably due to the large issuance of Treasury Bills, as the US Treasury replenished its cash balances following the reduction thereof during the debt ceiling debate of late 2017. This "liquidity squeeze" manifested itself in increased Libor-Fed Funds spreads, as participants decided to buy the bills instead of corporate and bank CP, thereby moving Libor wider. The broader question of what happens when the Fed reduces balance sheet, is unclear because we've never seen it before. At first glance, it might seem that the excess reserves will simply be replaced with Treasury bills and bonds, since these are HQLA just like excess reserves. However it does appear that banks may be unwilling to accept Treasuries as a replacement for excess reserves, in which case we can expect upward pressure on Fed Funds rates as banks continue to demand excess reserves.
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