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Trump's Treasury could cause financial market conditions to tighten even with Fed cut

Key Points
  • The Treasury is slated to borrow an additional $433 billion during the quarter that runs from July to September.
  • The Fed lowered its target range for the overnight funds rate by 25 basis points and ended its monthly $15 billion balance sheet reduction.
  • "The Treasury's cash balance decision is in some sense far larger in its impact on reserves than the Fed's decisions on what it did with its assets," said Lewis Alexander, chief U.S. economist at Nomura.
U.S. Treasury Secretary Steven Mnuchin talks to reporters about cryptocurrency in the Brady Press Briefing Room at the White House July 15, 2019 in Washington, DC. Mnuchin said the Treasury is very concerned about Facebook's Libra cryptocurrency and that he wants the government to "make sure that the U.S. financial system is protected from fraud.”
Chip Somodevilla | Getty Images

The Federal Reserve took steps toward easing monetary policy on Wednesday, but the Treasury Department, no longer constrained by the debt ceiling, is poised to perhaps tighten financial conditions through its upcoming funding actions.

On Monday, the Treasury Department announced an aggressive plan to build up its cash balances. The Treasury is slated to borrow an additional $433 billion during the quarter that runs from July to September, with a stated ending balance of $350 billion.

In comparison, the Treasury borrowed just $40 billion from April to June.

The large increase in debt issuance has the potential to partially offset the monetary easing just announced by the Fed. As the Treasury floods the market with new debt to rebuild its cash reserves, the new supply could have the effect of driving down prices and driving up yields of Treasurys and other market-determined interest rates.

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For its part, the Fed lowered its target range for the overnight funds rate by 25 basis points and ended the monthly balance sheet reduction it accomplished by allowing a capped level of proceed from the bonds it holds to roll off.

The upward pressure on short-term interest comes as the U.S. Treasury yield curve has been dancing around inversion for several months and 10-year Treasury rates are falling.

The Treasury's actions "could potentially continue to keep the yield curve inverted," said Brian Rehling, co-head of global fixed income strategy at the Wells Fargo Investment Institute. "We got positive before the Fed meeting, at least on 3-months to 10 [year] ... but post-Fed meeting we're inverted again."

Lewis Alexander, chief U.S. economist at Nomura, told clients in a note Thursday that the Treasury's actions could put upward pressure on market interest rates and lead the Fed to establish a short-term repo facility and expand its balance sheet. The facility would allow banks to exchange Treasurys for reserves. Alexander told CNBC that the new debt won't necessarily fully offset the interest rate cut but does limit any impact from ending the balance sheet roll-off.

"The Treasury's cash balance decision is in some sense far larger in its impact on reserves than the Fed's decisions on what it did with its assets," Alexander said.

The Treasury's cash buildup will occur during a dead period for the Fed, which doesn't meet again until mid-September. A slight majority of traders currently expect another rate cut then, according to the CME's FedWatch tool.

Larry McDonald, editor of The Bear Traps Report, said the combination of the strong dollar and Treasury action will push the Fed to more monetary easing.

"This dollar funding problem is already causing problems, in terms of behind the scenes, like repo, so financial conditions are going to change and force the Fed to soften more," McDonald said.

The Trump administration and congressional leaders agreed last month on a budget and debt ceiling deal that waives the debt ceiling until 2021, and the Senate passed the deal Thursday. Treasury Secretary Steve Mnuchin had warned Congress that the department could run out of cash in early September.

The U.S. federal deficit has continued to expand after the Trump administration's 2017 tax cuts, as revenues have failed to keep pace with rising spending. The deficit hit $779 billion in fiscal 2018, a 17% rise compared with the year before the tax cuts went into effect.

The deficit is on pace to expand again in fiscal 2019. The Treasury Department reported a deficit of $747 billion through the first three quarters, which ended in June.

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