What if banks were to buy US Treasuries?

The agreement on the US debt ceiling has been reached, but the standoff of the past months weighs on the Treasury’s coffers. As we outlined in our first article of the series, “Who will buy US debt?”, in a few months, the government will have to replenish its coffers by issuing a significant amount of government bonds. It is estimated that between $600 billion and $700 billion will need to be raised to replenish government funds, plus an additional $500 billion to cover current state expenses. This is a considerable amount to recover, which is feared to create stress in the market. As mentioned, there are two entities designated to purchase the debt: banks and funds operating in the money market. In this article, we will delve into what would happen if banks were to buy the majority of US Treasury bonds.

And if banks were to buy the debt?

The US banking sector is not going through an easy period. In March, it was shaken by the failure of three regional credit institutions, and more generally, banks have been facing a year of continuous interest rate hikes by the Federal Reserve, putting them under considerable pressure. The Treasury’s liquidity demand could further shake up the banking institutions, as it would reduce liquidity in the market, limit their ability to provide loans to businesses and consumers, and make banks more vulnerable to new financial shocks.

The challenges for banks

The issuance of new government bonds in the market could put pressure on banks in two different ways.

The first concern relates to competition. Businesses and households will be encouraged to invest in US debt rather than keeping their deposits in banks, as the average returns on investments in government bonds are relatively lower. If banks are forced to increase interest rates on deposits to continue attracting customers, their profit margins will decrease. Another consequence is that interest rates may further increase on all types of loans provided to individuals or businesses.

Secondly, a rush towards government bonds will reduce the overall amount of reserves that banks have access to at the Federal Reserve. This would decrease liquidity within the financial system, pushing interest rates even higher.

The reduction in market liquidity would then increase the possibility of disruptions, as brokerage firms, hedge funds, and other financial institutions rely on the market as their primary source of funding.

What could happen now?

The fear is to repeat the episode of September 2019, when liquidity management contributed to raising interest rates. In the overnight market, the Federal Reserve had indicated that its effective interbank rate had risen from 2.14% to 2.25%. This situation created turbulence, effectively forcing the central bank to intervene with liquidity injections (amounting to $260 billion) that hadn’t been seen since 2008.

This is a scenario that the central bank hopes to avoid, as it evaluates plans to gradually reduce the reserve supply. Of course, it remains a fact that the Treasury will issue sufficient government bonds to meet the need for a secure cash reserve.