After the debt ceiling agreement, the T-bills déluge

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So we have a debt ceiling agreement. It has yet to actually be approved by Congress and the Senate, and aims this military-grade idiocy only until the end of 2024, but how Matt Yglesias writesoverall it seems like a reasonable deal.

However, like us he 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.

Since reaching the debt ceiling, the US government has withdrawn money held in the Treasury’s general account at the Fed. As a result, its balance has fallen from about $700 billion at the end of 2022 to less than $50 billion. dollars now. The rapid rebuilding of that reserve will increase Treasury issuance to $730 billion over the next three months and about $1.25 trillion over the remainder of the year, according to Morgan Stanley.

This excess could cause problems in an already risky environment for markets, said Vishwanath Tirupattur, head of fixed income research at Morgan Stanley:

The consequences of this expected explosion of Treasury issuance on banking system liquidity and on short-term rates could be significant. The outcome depends critically on who buys the Treasuries and how. Some context may be helpful here. As the Fed tightened monetary policy to fight inflation by rapidly raising the federal funds rate, we have seen a steady outflow of funds from bank deposits into money market funds (MMFs), which has increased sharply after the regional banking woes started in March. Debt ceiling concerns have added to liquidity parked in MMFs, which reached an unprecedented $5.81 trillion as of May 25. .

While MMFs are the “natural” buyers of the T-bill deluge to come, the yield must be above the RRP rate in order to buy them. This means higher funding costs in short-term money markets, which in turn would add to liquidity challenges for banks. Furthermore, if the future path of monetary policy remains uncertain, MMFs would be reluctant to exit RRPs into Treasuries, especially if it means extending the maturity of the securities in their portfolios. Liquidity stresses remain for regional banks, as suggested by their continued reliance on the Bank Term Lending Facility (BTFP), which surged to $91 billion this week. On the other hand, if other investors were to buy Treasuries, they would have to do so using funds invested in other assets, which could drain liquidity into the system for those assets. Either way, the risk of increased market volatility looms large.

In this context, the relative calm pervading the markets leaves us perplexed. The volatility of the stock, interest rate and credit markets appears relatively contained and well below the levels seen in March. Looking back on 2011, the markets were also quite calm before date X, but have moved strongly since then. In the three weeks following the settlement, the S&P 500 fell more than 12%, 10-year Treasury yields fell by 70 basis points and high-yield bond index spreads widened by more than 160 basis points. In our view, these changes are due in part to the fiscal contraction foreseen in the deal that resolved the 2011 debt ceiling impasse. We do not yet know what the current resolution will entail, and we would caution against expecting such a reaction. market this time, especially in Treasury yields.

Overall, the risks ahead after the resolution of the debt ceiling issues make us think. We recommend a defensive positioning and would like to be underweight equities relative to high grade bonds in developed markets.

Morgan Stanley has been pretty bleak for some time, so this could be the case for analysts simply looking for a catalyst – any catalyst – to justify preconceived opinions.

For example, if the debt ceiling agreement passes, the Treasury has two years until the next debt ceiling deadlock and may decide to take a more measured approach to rebuilding the TGA. And the situation in 2011 was radically different than it is today, so we wouldn’t extrapolate too much from that.

That said, the level of Treasury issuance in the pipeline undoubtedly comes at a time of rightly heightened liquidity concerns and won’t help things calm down.