After the debt ceiling agreement

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Good day. Kate here. Thank you so much for having me back on Unhedged while Ethan and Rob are free. It was wonderful to hear from you last time, and I’d love to hear your views again today, especially on debt ceiling risks that you feel aren’t getting enough attention. Email me: kate.duguid@ft.com.

What happens after the debt ceiling agreement?

Lawmakers in Washington are negotiating a deal to raise the debt ceiling. The Speaker of the House of Representatives, Republican Kevin McCarthy has known President Joe Biden this week and Federal Reserve Chairman Jay Powell have also weighed in. At stake is a US debt default, which may occur if no deal is reached by June 1.

The exact contours of a deal will be important to the markets. But I’m also curious about what happens after a resolution is reached. Suppose that within a week Congress raised the debt ceiling and prevented a US default. What then?

The United States hit its $31.4 trillion debt limit in January and has been using “extraordinary measures” (i.e., pulling spare coins out of sofa cushions) ever since to pay its bills. As soon as an agreement is reached, it will be necessary to borrow a lot of money to replenish the coffers of the Treasury Department. Jay Barry, co-head of US rate strategy at JPMorgan (who cleverly titled his note on the subject “Après moi, le déluge”), has said that his estimates call for the Treasury to issue around $750 billion in bills in the four months following a resolution, with approximately $1.1 trillion in the last seven months of 2023.

Someone has to pay cash for all those new Treasuries, sucking liquidity out of the system. Analysts say this rush of issuance could put pressure on banks and raise borrowing costs as the US economy continues to slow.

Quantitative tightening has already led to a lot of cash withdrawn from bank reserves. A flood of Treasury bills could exacerbate that drain, enough to force the Fed to question whether it can maintain QT, Barry says.

The pain is not limited to the bond market. A debt deal will likely mean cuts in government spending that could slow economic growth and hurt stocks, says Jake Jolly, director of investment research at BNY Mellon.

“There seems to be a view that there will be a relief pick-up on the deal. I think it’s a big mistake. That didn’t happen in 2011. The austerity that came with that deal was more than the market expected. Today, my concern is that while no debt ceiling debate is quite the same, this one could hit markets more negatively.”

The liquidity squeeze in the market from the increase in the issuance of Treasury bills is also likely a risk for stocks. Michael Wilson, an equity strategist at Morgan Stanley, warned over the weekend that “while a debt ceiling resolution removes a near-term market risk, material dislocation and increased risk to investors was never priced in.” markets now is that the increase in the debt ceiling could decrease. market liquidity based on the significant Treasury issuance that we expect within six months of approval.” In other words, even an orderly end to the debt ceiling drama could prove detrimental.

Money market funds, mutual funds that invest in short-term debt, could help cushion the blow by absorbing some of this supply.

Money market funds have typically had a large portion of their holdings in Treasury bills, but that proportion has changed in the past two years as money funds have become increasingly reliant on the Federal Reserve’s reverse repo facility. This program, which allows certain investors to store cash there overnight, has attracted large flows since 2021 because it offers generous returns without risk. Every night about 2.3 billion dollars are saved in the RRP.

A flood of Treasury bill supply should mean lower prices and higher yields, making the bills more competitive at RRP for money market funds, which have plenty of cash to put to work.

While this should help, the amounts of debt to be issued are huge and may ultimately require intervention in the form of the Fed such as, perhaps, the end of QT.

shorts season

Speculative traders such as hedge funds hold the largest short position on record in two-year Treasury futures. You can see the position in the weekly data published by the Commodity Futures Trading Commission shown below:

If it were a straight short position, it would be a way of betting on a rise in two-year yields and a fall in price. Since two-year yields move with interest rate expectations, that would suggest that speculators were betting on more interest rate hikes from the Fed or higher rates for longer.

The CFTC data is an aggregate and certainly captures some traders who are making that bet. But investors and analysts cautioned that the bulk of the position is likely part of a relative value trade, along with a long cash position, which benefits from price dislocations between comparable securities in the futures and equity markets. cash. It is a bet on price peculiarities, not rate fundamentals.

The head of rate trading at a large US hedge fund, who was unable to speak officially, said: “I think what you’re seeing in the hedge fund numbers is not a directional bet but a value bet.” relative. . . These are relative value strategies, in the trading and accessory community as well as hedge funds, essentially being short futures and long cash.”

Shorting two-year Treasuries has been a painful profession this year. speculators They were in record shorts in two-year futures just before the collapse of Silicon Valley and Signature banks. The turmoil at those banks led investors to buy two-year Treasuries, betting that the Fed would be forced to cut interest rates and seeking safety in the safe haven of the Treasury market. The switch to two-year notes trapped hedge funds that were short and forced them out of those positions, creating huge volatility in the market. The price changes were large enough to raise concern from regulators.

As Ethan and Rob often say, the peak of the tightening cycle is often when things in the markets break down. That makes this a risky time to be in a large short position in a part of the market that attracts investors in turbulent times, both because of its safe-haven quality and because it is the place to express views about the next Fed move.

The other season of shorts

Rob has mentioned she wears shorts in passing in her fashion columns, but has never addressed the issue head-on. (Coward.) Here, then, from the FT archives is one piece about whether you can wear shorts to the office.