The deep logic behind the sharp drop in US Treasury bonds lies in the speech of this senior official at the Federal Reserve

With the combined boost of the warming up of the U.S. economy and the increased possibility of Trump's re-election, the replay of the 1995 U.S. Treasury sell-off has triggered a global market resonance.

In addition to these widely recognized factors, what can we see from a fund perspective to analyze the deep logic behind the sharp drop in U.S. Treasuries? Dallas Fed President Lorie Logan provided some important clues in her speech on October 21.

In a research report on October 22, Bank of America Merrill Lynch provided a detailed analysis of Logan's speech, stating that Logan believes the sharp drop in U.S. Treasuries stems from the tightening market financing conditions caused by balance sheet reduction, and the market needs to "tolerate normal, moderate, and short-term pressure." The current effectiveness of improving market liquidity through the Fed's repurchase clearing mechanism seems limited.

Furthermore, Bank of America Merrill Lynch also mentioned that Logan's speech seemed to overlook a key point, that is, if the debt ceiling is reached again, the balance of the Treasury General Account (TGA) will decrease, which is a crucial signal to restrain the financing market and will affect market confidence in assets such as U.S. Treasuries.

Logan: "Tolerate normal, moderate, and short-term pressure" during the balance sheet reduction process, especially with continuous growth in U.S. Treasury supply

Logan stated that market liquidity is still very abundant. Compared to the investor return benchmark rate (IORB), the Treasury General Cash Return (TGCR), and the Federal Funds Rate (FF) are all at low levels, reflecting ample funds in the market, with sufficient liquidity available for investment and low financing costs.

To address excessive market liquidity, the Fed is reducing its balance sheet, and in this process, Logan believes that it is necessary to "tolerate normal, moderate, and short-term pressure in the money market," meaning that financing costs will rise.

Moreover, Logan believes that the low Treasury General Cash Return (TGCR) and the high Secured Overnight Financing Rate (SOFR) also reflect that, although market liquidity is ample, dealers still face some restrictions (possibly due to regulatory requirements), indicating a tense financing market situation. With the introduction of relevant regulations, these restrictions may become more significant.

In addition, the continuous growth in U.S. Treasury supply is an unavoidable core risk. Bank of America Merrill Lynch analysts mentioned that Logan implied that with the continuous growth in U.S. Treasury supply, financing costs will also rise, leading to a drop in U.S. Treasury prices and an increase in yields.

Logan: Limited effectiveness of the Fed's repurchase clearing mechanism

So, if U.S. Treasuries continue to plummet and the market faces a liquidity crunch, can the Fed's repurchase clearing mechanism solve the immediate problem?

Logan stated that although the Fed's repurchase clearing can help dealers more effectively manage the risk exposure of their balance sheets, better manage the repurchase cash borrowed and lent from the Fed, and improve fund efficiency However, this is unlikely to be achieved quickly, as Logan believes there are two main obstacles: the counterparty risk considerations of the Federal Reserve and the margin requirements of CCP.

(Counterparty Risk Considerations: This refers to the risk of one party not fulfilling its contractual obligations in financial transactions. For the Federal Reserve, as a central bank, its responsibility is to maintain financial stability, hence the need for strict assessment of participants' credit conditions and market risks.

CCP Margin Requirements: CCP stands for Central Counterparty. It is a financial market infrastructure aimed at reducing credit risks between trading parties and enhancing market transparency and efficiency. If the Federal Reserve chooses to conduct repurchase clearing with CCP, market participants may face higher margin requirements, potentially increasing their financing costs.)

In this scenario, the Federal Reserve's cautious approach to risk control may lead to reluctance to swiftly advance repurchase clearing, meaning that even if there is a plan, actual implementation may require a longer time.

Moreover, even if the Federal Reserve implements repurchase clearing, participants facing high margin requirements may still need to seek cheaper U.S. Treasury bonds to lower financing costs and manage risks, further causing a decline in Treasury bond prices.

BofA: Logan Missed a "Key Point" - Government Debt Ceiling and TGA Balance

BofA also added that they believe Logan missed a crucial point (possibly due to political sensitivity), which is the lack of discussion on the U.S. debt ceiling, an important factor currently affecting the financing environment.

BofA believes that if the debt ceiling is reached again, the government's cash flow will be affected, and the balance of the Treasury General Account (TGA) will decrease, sending a critical signal to restrain the financing market.

Market participants typically adjust their risk assessments and expectations based on changes in the TGA. If investors anticipate tighter financing conditions, their confidence in certain assets (such as U.S. bonds) will decrease as a result.

Recent comments from Logan and other Federal Reserve officials indicate their willingness to continue QT during the debt ceiling period until clearer signals of financing pressure emerge, although this approach may lead to unexpectedly sharp tightening of the financing environment during the TGA rebuilding period.