Après debt ceiling deal, le T-bill deluge

So we have a debt ceiling deal. It still has to actually be passed by Congress and the Senate, and will only lead to this gun-class crap until late 2024, but Matt Iglesias writesIt seems like a reasonable deal overall.

However, as we wrote last week, even a debt ceiling deal does not mean that we will avoid negative financial and economic consequences from the whole boring saga.

Ever since it hit the debt ceiling, the US government has been withdrawing money held in the Treasury’s general account with the Federal Reserve Bank. As a result, its balance there has fallen from about $700 billion at the end of 2022 to less than $50 billion now. Rapidly rebuilding that reserve would boost Treasury issuance to $730 billion over the next three months, and about $1.25 trillion over the rest of the year, according to Morgan Stanley.

This glut could spell trouble at an already difficult juncture for the markets, says Vishwanath Tirupatore, head of fixed income research at Morgan Stanley:

The consequences of this expected rush of T-bills issuance for banking system liquidity and short-term rates could be significant. The outcome depends critically on who buys treasury bills and how. A little context might be helpful here. As the Fed has tightened monetary policy to combat inflation by quickly raising the federal funds rate, we have seen a steady flow of money from bank deposits into money market funds (MMFs), which have rebounded significantly after the regional banking problems that started in March. Debt ceiling concerns have added to the stalled liquidity at MMFs, which reached an unprecedented $5.81 trillion as of May 25. MMFs, in turn, deposited their money to the Federal Reserve using reverse repurchase agreements (RRPs), earning the reverse repo rate. .

While MMFs are the “natural” buyers of the incoming flood of T-bills, the yield would have to be above the RRP price for them to buy them. This means higher funding costs in short-term money markets, which in turn will add to liquidity challenges for banks. Moreover, if the future path of monetary policy remains uncertain, MMFs will be reluctant to exit RRPs and into T-bills, especially if it means extending the maturity of the securities in their portfolios. Liquidity pressures for regional banks remain, as suggested by their continued reliance on the Bank’s Term Facility (BTFP), which crept up to $91 billion this week. On the other hand, if other investors buy Treasury bills, they will have to do so using money invested in other assets, which can drain liquidity in the system for those assets. Either way, the risks of increased market volatility loom large.

Against this background, the relative calm prevailing in the markets seems baffling to us. Volatility in the equity, rate and credit markets appears to be relatively contained and well below March levels. Looking at 2011, the markets were also fairly quiet prior to the 10th date but then recorded sharp moves. In the three weeks since the decision, the S&P 500 fell more than 12%, the 10-year Treasury yield fell by 70 basis points, and high-yield index spreads expanded by more than 160 basis points. In our view, these changes resulted in part from the fiscal downturn embedded in the agreement that resolved the 2011 debt ceiling impasse. We do not yet know what the current decision will entail and we would caution to expect a similar market reaction this time around, particularly in Treasury yields.

In general, the risks that lie ahead after debt ceiling issues are resolved make us pause. We advise defensive positioning and short stocks against high quality bonds in developed markets.

Morgan Stanley has been very dismal for a while now, so this may be a case of analysts simply looking for a catalyst – any catalyst – to justify preconceived views.

For example, if the debt cap deal passes, the Treasury has two years until the next debt cap encounter, and could decide to take a more measured approach to rebuilding the TGA. And the situation in 2011 was very different from what it is today, so we will not overextrapolate this.

However, the level of T-bills issuance in the pipeline undoubtedly comes at a time when concerns about liquidity are justifiably high, and that will not help calm things down.