Commercial Banks Taper Treasury Purchases | Joseph Wang & DC Analyst

Episode Summary

Executive Summary: The episode examines how post-COVID bank balance sheet growth made commercial banks major buyers of Treasuries and agency MBS, and why that demand is now fading as deposits stall and loan demand improves. The guests argue QT’s next phase will hinge on Treasury issuance, money funds, and leverage players, with the Treasury market likely the system’s most fragile point. They also discuss MBS runoff challenges, BOJ/YCC risks, and whether higher rates will help or hurt bank profitability.

Main Topics: Why banks bought Treasuries after COVID (Priority: 5/5): DC explains that fiscal spending flooded banks with reserves and deposits while rates were near zero, forcing banks to swap low-yield cash into Treasuries and agency MBS to earn return on balance sheet space. Why bank Treasury buying is slowing (Priority: 5/5): The guests say deposit growth has largely stopped and banks are seeing more loan demand, so cash is increasingly being deployed into loans rather than securities. How QT differs from 2018 (Priority: 5/5): DC argues the post-2020 system has more central bank backstops, higher bank liquidity, and stronger repo guardrails, meaning stress should first appear in peripheral funding markets and Treasury market liquidity rather than in overnight plumbing. Who will absorb the Fed’s Treasury runoff (Priority: 5/5): They debate whether banks, money market funds, foreigners, or hedge funds will absorb the Fed’s planned balance sheet reduction, concluding that higher yields may be needed to attract enough buyers. Treasury market fragility and leverage (Priority: 5/5): Joseph and DC stress that Treasury issuance has grown much faster than market trading capacity, making the market vulnerable to disorderly moves, especially if leveraged basis traders step back or BOJ actions shock global rates. Mortgage-backed securities runoff challenges (Priority: 4/5): MBS are harder to manage than Treasuries because prepayments depend on home sales and refinancing; rising mortgage rates can extend duration and slow runoff, making the Fed’s MBS QT less predictable. Bank profitability and rates (Priority: 4/5): The speakers debate whether higher short rates are bullish for banks. Joseph argues banks are more asset-sensitive post-Basel III and can reprice assets faster than deposits; DC notes NIMs are still low and benefits depend on deposit pricing behavior.

Key Arguments: Banks became major Treasury buyers because reserve balances and deposits surged after fiscal spending, but that mechanical demand is now fading. The end of rapid deposit growth and a pickup in loan demand reduce banks’ need to park excess cash in Treasuries and MBS. QT in 2022+ is less likely to break overnight funding than 2018 because the Fed now has the standing repo facility, foreign repo facilities, and more bank liquidity. The most fragile market is likely the Treasury market itself, because issuance is enormous relative to daily trading capacity. If banks are not the marginal buyer, higher yields will be needed to bring in money funds, foreigners, and levered relative-value hedge funds. Japan’s BOJ/YCC policy is a potential catalyst: any discrete upward move in JGB yields could transmit globally and pressure USTs through portfolio reallocation and duration losses. MBS runoff is harder to control than Treasury runoff because refinancing and home-sale behavior determine paydowns, and higher mortgage rates can slow or self-reinforce duration extension. Higher rates may help bank earnings if deposit costs remain sticky near zero, but not all banks benefit equally and the effect can be slow to show up in NIMs.

Data Points: Fed Treasury runoff target: $60 billion per month - Discussed as the planned monthly Treasury QT pace over roughly the next three years. Fed MBS runoff target: $35 billion per month - Discussed as the cap for mortgage-backed securities runoff under QT. Total monthly QT target: $95 billion per month - Sum of the Treasury and MBS QT caps referenced by the guests. Estimated MBS paydown: About $25 billion per month - Joseph cited New York Fed estimates for expected MBS principal paydowns. Fed Treasury holdings runoff horizon: About $3 trillion over three years - Approximate amount the private sector would need to absorb if QT proceeds as planned. Fed/Treasury trading capacity comparison: Outstanding Treasuries up ~7x over 20 years; cash trading less than doubled - Joseph used this to argue Treasury market liquidity has not kept pace with issuance growth. Bank deposit growth since 2020: Deposits up about 50% - DC used this to explain why banks had excess cash to deploy into securities. Bank net interest yield example: Bank of America: 1.68% to 1.69% - Joseph and Jack used this to show NIM improvement can be slow despite rising rates. Fed balance sheet backstop numbers: Standing repo facility described as theoretically $500 billion; RRP referenced as $1.7 trillion - Used to illustrate the scale of Fed liquidity backstops, with the caveat that the Fed uses very large notional limits. Rate hike pricing: Two consecutive 50 bp hikes priced; market debating 50 vs 75 bp - Discussion around Bullard’s remarks and how they affected rate futures. JGB shock example: Potential 25 bp move in Japanese yields - DC said a discrete move of this size could transmit through global bond markets. USD/JPY move: From 110 to 130 - Used to illustrate the speed of yen depreciation and potential BOJ pressure to respond. Historical reference: Q4 2018 - Used as a comparison for past QT stress and equity market weakness.

Pivotal Quotes: "The fragility really is probably in the Treasury market." — Joseph Wang: He argues Treasury market depth has not scaled with issuance, making it the likely pressure point during QT. "It was the commercial banks that emerged as a marginal buyer in the post-COVID world." — Joseph Wang: He explains who absorbed much of the post-2020 Treasury and agency supply. "The market is able to withstand until it gets that bad." — DC: He describes how liquidity can appear fine until a sudden disorderly episode forces the Fed back in as buyer of last resort.

Implications: Listeners should expect QT to matter more through Treasury-market liquidity, funding spreads, and mortgage rates than through immediate banking-system breakdowns. Higher yields may eventually attract buyers, but the path could be volatile and disorderly.