- From private-led to public-led financial stability. For four decades, the recycling of foreign savings into US assets delivered low rates, abundant collateral and private liquidity creation for countries around the globe. Yet as foreign demand for US Treasury securities has weakened over recent years, stability has come to rest increasingly on public backstops from the US Federal Reserve (Fed) and, increasingly, the US Department of the Treasury. In effect, their interventions stabilize a highly leveraged system in which most risk assets sell off when rate volatility rises.
- A first generation of tools, led by the Fed, managed abundant liquidity. After the 2008 Global Financial Crisis, quantitative easing (QE), was complemented by a raft of tools that created a policy-rate corridor, with Interest On Reserves Balances (IORB) serving as a ceiling and Reverse Repo Program (RRP) as a floor, along with the Foreign and International Monetary Authorities (FIMA) repo facility and central-bank swap lines to contain funding volatility and backstop offshore dollar demand. This framework relied on low inflation until Covid changed the macro backdrop.
- Now, a second generation, increasingly led by the Treasury, manages frictions. Since the Silicon Valley Bank (SVB) crisis in March 2023, T-bill supply has surged from about USD3.8tn to USD6.7tn, reflecting deficit financing and the rebuilding of the Treasury's cash balance as well as debt-management choices, and has drained the RRP from its USD2.6tn peak in April 2023. Alongside the Fed's Standing Repo Facility, the toolkit also includes a shorter debt maturity, buybacks, bank balance-sheet relief and the GENIUS Act. Together, these have acted as a form of “indirect QE”: by reducing the duration supply available to private investors, they lowered 10-year yields by an estimated 25bp even as the Fed implemented quantitative tightening, although term premia still rose. But this has come at the cost of higher financing costs over the long term and shorter debt horizons.
- The structural forces behind fragmentation keep strengthening. Rising defense, energy and industrial financing needs are keeping more savings at home for those countries that used to recycle their excess cash into the US capital markets. On top of this, reserve managers are progressively diversifying away from the USD, and the marginal foreign buyer of Treasuries is no longer central banks, but price-sensitive, leveraged investors domiciled in offshore centers. As a consequence, the volatility of long-term Treasury inflows has risen to about 3.7%, against a 2.6% average since 2009, and Treasuries increasingly sell off alongside equities. Beyond higher inflation uncertainty, this is eroding the safe-asset status of US debt securities.
- Policy backstops buy time, but they cannot reverse the shift. In our base case, fragmentation points to higher term premia, a weaker USD over the medium term, more domestic bond markets and a larger role for gold.