So we have a debt ceiling deal. It still needs to actually be passed by Congress and the Senate, and only punts this weapons-grade idiocy into late 2024, but as Matt Yglesias writes, it seems a reasonable deal overall.
However, as we wrote last week, even a debt ceiling deal doesn’t mean that we will avoid negative financial and economic consequences from the whole tedious saga.
Since it hit the debt ceiling the US government has been drawing down money held in the Treasury General Account with the Fed. As a result its balance there has dropped from about $700bn at the end of 2022 to under $50bn now. Quickly rebuilding that buffer will boost Treasury bill issuance to $730bn over the next three months, and about $1.25tn over the rest of the year, according to Morgan Stanley.
This glut could cause problems at an already dicey juncture for markets, argues Vishwanath Tirupattur, head of fixed income research at Morgan Stanley:
The consequences of this expected burst of T-bill issuance for liquidity in the banking system and short-term rates could be meaningful. The outcome depends critically on who buys the T-bills and how. A bit of context may be useful here. As the Fed tightened monetary policy to combat inflation by rapidly raising the fed funds rate, we have seen a steady outflow of funds from bank deposits into money market funds (MMFs), which picked up dramatically after the regional banking problems that began in March. The debt ceiling concerns have added to the cash parked at MMFs, which reached an unprecedented US$5.81 trillion as of May 25. MMFs in turn have deposited their cash at the Federal Reserve using reverse repo purchase agreements (RRPs), earning the reverse repo rate.
While MMFs are the ‘natural’ buyers of the deluge of T-bills to come, the yield needs to be above the RRP rate for them to buy them. This means higher funding costs in the short-term money markets, which in turn would add to liquidity challenges for banks. Furthermore, if the path ahead for monetary policy remains uncertain, MMFs would be reluctant to get out of RRPs and into T-bills, especially if it means extending the maturity of securities in their portfolios. Liquidity stresses for regional banks linger on, as suggested by their continued reliance on the Bank Term Lending Facility (BTFP), which crept up to US$91 billion this week. On the other hand, if other investors were to buy the T-bills, they would need to do so using funds invested in other assets, which could drain liquidity in the system for those assets. Either way, the risk of heightened market volatility looms large.
Against this backdrop, the relative calm that pervades markets seems puzzling to us. Volatility in equity, rates and credit markets appears relatively contained and well below March levels. Looking back to 2011, markets were also fairly calm before the X-date but subsequently registered sharp moves. In the three weeks after the resolution, the S&P 500 fell by over 12%, 10-year Treasury yields declined by 70bp and high yield bond index spreads widened by more than 160bp. In our view, these changes resulted in part from the fiscal contraction embedded in the agreement that resolved the 2011 debt ceiling impasse. We don’t know yet what the current resolution will entail and would caution against expecting a similar market reaction this time, especially in Treasury yields.
Overall, the risks ahead after the debt ceiling issues are resolved do give us pause. We advise defensive positioning and would be underweight equities versus high grade bonds in developed markets.
Morgan Stanley has been pretty gloomy for a while now, so this could be a case of analysts simply looking for a catalyst — any catalyst — to justify pre-held views.
For example, if the debt ceiling deal passes the Treasury has two years until the next debt ceiling stand-off, and could decide to take a more measured approach to rebuilding the TGA. And the situation in 2011 was radically different from what it is today, so we wouldn’t over-extrapolate from that.
That said, the level of T-bill issuance in the pipeline unquestionably comes at a time of justifiably heightened concerns over liquidity, and is not gonna help things simmer down.
