The Fed's sudden change in direction has Wall Street worried that this market will be the first to be turbulent

Over the past year, the sales volume of U.S. Treasury bonds has been continuously rising, sparking a debate on Wall Street about whether there will be enough demand to avoid disrupting the financing market.

Since the beginning of 2023, the Treasury has issued $2.23 trillion in short-term Treasury bonds, and recently increased the supply to offset the government deficit. The interest payments on the U.S. debt balance continue to push up the federal government's budget deficit, which expanded to $1.27 trillion by the end of June of this fiscal year.

So far, the market seems to have calmly accepted this situation, as seen in the pricing of short-term Treasury bonds and other risk-free rate products (such as overnight index swaps), which have remained relatively stable. However, there are concerns that the eventual arrival of Fed rate cuts and quantitative tightening (QT) will lead to market liquidity stress. Some worry that this pressure may even resemble the turmoil that forced the Fed to intervene four years ago.

Torsten Slok, Chief Economist at Apollo Global Management, believes that once the Fed starts cutting rates (possibly in September), the appetite of households and money market funds may decrease, leading to upward pressure on short-term Treasury bond rates.

In a report last week, Slok wrote, "As the Fed conducts QT, the amount of outstanding Treasury debt continues to increase, increasing the risk of unexpected events in the money markets, which is exactly what we saw in the repo market in September 2019."

Others on Wall Street disagree. After the Fed raised rates to the highest levels in decades, investors flocked to the money markets, with the latest data showing that total money market assets reached $6.14 trillion, not far from the historical high set last week. They argue that these funds will continue to remain ample to seek higher returns.

Mike Bird, Senior Portfolio Manager at Allspring Global Investments, said, "Claims that demand for Treasury bonds will weaken during a Fed easing cycle are a bit exaggerated. Especially for money market funds, we will continue to maintain our appetite. This demand will not disappear."

As the Fed gets closer to cutting rates, money market funds are extending the duration of their assets - buying longer-dated Treasury bonds to lock in higher yields after rate cuts begin. This means that companies that have been directly buying short-term Treasury bonds will move cash into funds to take advantage of lagging yields, resulting in a greater appetite in the money markets.

Teresa Ho, Head of U.S. Short-Term Rates at JPMorgan Chase, said, "In the past three rate-cut cycles, funds do not flow out of money market funds until the Fed has gone far in the easing cycle, so funds continue to flow in. At least the current 4% to 5% yield is still high.

Since the Fed's first rate hike in March 2022, around $1.33 trillion has flowed into U.S. money market funds, with over half coming from retail investors. Deborah Cunningham, Chief Investment Officer for Global Liquidity Markets at Federated Hermes, Indicating that the previous asset size may have reached $70 trillion, especially because most of the cash from institutional investors such as companies has not yet been transferred.

In addition, money market funds are already the largest buyers of short-term government bonds, but facing new requirements from the Securities and Exchange Commission, they may become even larger buyers.

These measures are scheduled to take effect in October, imposing liquidity fees on some funds during financial stress periods, thereby increasing the cost of fund withdrawals. This will come at the expense of higher-risk assets, boosting demand for financial instruments such as Treasury securities.

On the supply side, as the debt ceiling is set to be reinstated on January 1, the market may face a decrease in issuance volume. Once this situation arises, government agencies will take measures to stay below the limit before exhausting their borrowing power, including significantly reducing the sale of short-term government bonds. This may create an imbalance at the front end, similar to the period from 2021 to 2023, where cash exceeds the amount of investable assets available.

Meanwhile, the Treasury will continue to issue short-term government bonds to fund larger deficits. Berd of Allspring said, "The Treasury will not issue bonds recklessly. This is where they can get the most funds when needed. They ensure that there is demand for the product."