Alternative Market Briefing

The consequences of the 2023 U.S. debt ceiling

Tuesday, June 13, 2023

amb
B. G., Opalesque Geneva:

The debt-ceiling negotiations are over. Last week, the U.S. Congress averted a sovereign default by allowing the government to resume borrowing. Meanwhile, the Treasury General Account (TGA, which is used for official payments) fell to just $23bn at the start of June, less than the amount of net spending on a typical day. The Treasury normally maintains a balance of $500bn minimum, enough for a week of cash outflows. So it must now sell bills and bonds and even more paper to finance the deficit; this will result in a surge in issuance.

The concern is where the money will come from and, in particular, if debt sales will drain liquidity from other markets, according to The Economist. The two main sources of cash are money market funds (currently $5tln are invested in them), and reducing the level of bank reserves. Money market funds could remove the bulk of the new bills by paring the cash they place at the Fed via its repurchase agreement (repo) facility, which means the Treasury may have to offer higher coupon rates. Higher yields would translate into higher funding costs. As for the second option, as banks have reserves of about $3tln, these reserves could easily reach $2.5tln, indicating reserve scarcity, jeopardising banking stability and forcing lenders to offer higher deposit rates. Reserve scarcity would not necessarily spell disaster, says the paper, as the Fed could provide liquidity support if necessary. But the flood of new issuance may add to market anxiety and volatility and increase risk.

In an Opalesque webinar last week moderated by Michelle Makori, editor-in-chief at Kitco News, a precious metals, commodities and mining news site in Montreal, Roy Niederhoffer, founder of R.G. Niederhoffer Capital Management, a 30-year-old New York-based quantitative trading advisor, and Michael Green, portfolio manager and chief strategist at Simplify Asset Management, a provider of options-based ETFS in New York, talked about the consequences of the recent debt ceiling agreement - and of what the current period reminds him.

A world of convexity

We are in a world of convexity that is unprecedented, what with the pandemic and what followed such as inflation and higher rates, starts Roy Niederhoffer, who later in the webinar talks about strategies that work during the current regime.

Now, there may be a credit event and a potential bear market for equities. He recalls the importance of the direction of credit spreads in a portfolio: the average returns for equities and hedge funds would most likely suffer with widening credit spreads, whereas narrowing credit spreads would more likely mean positive returns for equities, fixed-income and hedge funds, according to his research. This supports the stance in favour of diversifying portfolios.

Michael Green tackles the question as to whether the debt ceiling resolution will create a significant risk-off event.

The stimulus of U.S. government spending is usually balanced by the tightening impact of the U.S. Treasury issuing the same amount of bills, notes and bonds (or taxes), he explains. But for the last six months, because of the Debt Ceiling, that stimulus happened all alone. Just like QE, it compressed credit spreads, boosted equities, crushed volatility, and muted the impact of Fed tightening. It also helped mask underlying economic weakness caused by higher interest rates. Meanwhile, many companies have been waiting to issue more than a trillion dollars in new debt, hoping to issue it at lower rates than today.

In essence, government spending raises liquidity and government borrowing reduces liquidity. When the Treasury spends down the TGA without raising taxes or selling bonds, the savings must be invested elsewhere.

Now we need to refill the TGA

The Treasury General Account (TGA) did not exist until 2015, he says. It is very rapidly becoming an extremely influential component of liquidity in the U.S., in the equity market and the fixed-income market. It has become almost identical to the SPR (Strategic Petroleum Reserve). And now we need to refill the TGA.

"The release of funds from the TGA has actually exceeded the quantity of tightening that has come from the Fed. So we have had net liquidity injections into the financial markets (in various ways). The risk is that it tightens the price of money for every other financial asset. That's what we talk about when we talk about credit spreads blowing out, the S&P falling, etc.

"We are seeing a significant increase in supplemental issuance in which bonds are now being issued to refill the TGA. It will be mostly bills typically in the 3-month to 6-month point; that places less pressure on the financial markets. And there is going to be a very strong incentive to not push this through the banking system and instead try to get money market funds effectively marketing directly to money market funds, which should lead to a modest increase in the Treasury rates versus the Fed fund's rates. We should see a small spread emerge in which the Treasury is trying to get money market funds to take in these assets. At the same time, not all of it is going to occur, not everything will come out of money market funds. It is going to place additional pressure on the banking systems taking these funds."

What the spreads are reflecting

Despite the fact that the TGA has been drawn down, which would normally lead to an increase in banking deposits in the private sector, bank deposits are falling rapidly, he said. This is a function of quantitative tightening itself. Another part of it is the money market funds drawing deposits away from the banking system because they offer superior returns to the banks.

"But the real challenge within the banking sector is that they can't get the higher yields that are required for them to raise interest rates on deposits and compete with money market funds. So as long as we are talking about these dynamics, we would expect to see continued pressure on the banking system. The rate of drawdown we have seen in the banking system in terms of deposits from peak is falling at an exceptionally rapid rate."

"If all of this was already happening against a backdrop in which risk was already evident in the market, I would not really be raising concerns," he adds. "But what we are actually seeing is that the spreads, particularly in the high yield and to a lesser extent in investment grade, already reflect extremely loose monetary conditions. What I think is happening here is something very similar to what happened prior to the global financial crisis of 2007..."

You can watch the rest by replaying the webinar here: www.opalesque.com/webinar/#pastwebinar