The Hidden Engine: How Collateral Fuels Financial Markets
Unraveling the secrets of re-used assets, safe bets, and market crashes
Financial Collaterals: What is it, what does it do, and how does it impact the financial system?
At the January 29th Quarterly Refunding Announcements, the US Treasury reduced its estimate for federal borrowing for the current quarter to $760 billion in net borrowing for January through March while intending to keep the Treasury General Balance (TGA) at $750 billion. Think of the TGA account as the checking and savings account for the Government.
If you recall, the US government was in a predicament just over 8 months ago, in June 2023. The government had reached its debt limit and would default on its debt obligations as it had run the TGA balance to the lowest levels seen since 2018. This caused a short-term market route which resulted in the price across front-end bonds, particularly 1m-1year T-bills, as investors holding securities set to mature around the X date (default date) demanded higher yields for the increased volatility and risk. I was short the front end of the curve leading up to the X date.
As a rule of thumb, every time the government has to replenish the TGA account they do so through issuing T-bills rather than long-duration bonds (10y, 20y etc).
The government do this for three main reasons: Liquidity, Interest Rate Risk and Market Efficiency.
Liquidity: T-bills have maturities ranging from one day to one year, making them highly liquid assets. The TGA needs instant access to cash to handle daily government expenses and unforeseen events. Longer-duration bonds, while offering higher returns, are less liquid and can be difficult to sell quickly when needed.
Interest Rate Risk: Interest rates fluctuate, and holding long-duration bonds exposes the government to interest rate risk. If interest rates rise, the value of existing bonds falls. Since the TGA needs predictable cash flow, minimizing interest rate risk is crucial. T-bills have minimal exposure to this risk due to their short maturities.
Market Efficiency: The T-bill market is large and efficient, with frequent auctions and high trading volume. This allows the government to easily buy and sell T-bills without significantly impacting their price. Longer-duration bond markets, while still large, may be less efficient, making it more expensive and complex for the government to buy and sell large quantities.