By Shankar Ramakrishnan, Davide Barbuscia, Saeed Azhar and Laura Matthews
(Reuters) – Good news about a tentative deal for the US debt ceiling deadlock could quickly turn into bad news for financial markets.
US President Joe Biden and top congressional Republican Kevin McCarthy reached a preliminary agreement on Saturday to raise the federal government’s debt ceiling of $31.4 trillion, two sources familiar with the negotiations said, triggering an economically destabilizing bankruptcy possibly prevented.
But the deal still faces a tough road to pass through Congress before the administration runs out of money to pay its debts in early June.
“This will be pretty good for the market,” said Amo Sahota, director at KlarityFX, adding that it could be more reason for the US Federal Reserve to be confident in raising rates again.
“Although we want to see what the … deal looks like,” Sahota added.
While an end to uncertainty would be welcome, the relief a deal brings may be a short-lived relief for investors. That’s because once a deal is struck, the U.S. Treasury is expected to quickly fill its empty coffers with bond issuance, sucking hundreds of billions of dollars of cash out of the market.
The cap increase is expected to be followed by the issuance of nearly $1.1 trillion in new Treasury bills (T-bills) over the next seven months, according to recent estimates from JPMorgan, a relatively large amount for that short period.
This bond issuance, presumably at the current high interest rates, is depleting banks’ reserves as deposits from private companies, among others, shift to higher-paying and relatively safer government debt.
That would reinforce an already prevailing trend of deposit outflows, put more pressure on liquidity, or available cash, available to banks, drive up rates on short-term loans and bonds, and make financing more expensive for companies already struggling. have a high interest rate. assess environment.
“There will certainly be a relief in fixed income markets,” said Thierry Wizman, global FX and interest rate strategist at Macquarie.
“But what this doesn’t fix is that all along the government bond curve, yields have been rising lately… in anticipation of a lot of government bonds and banknotes being issued in the coming weeks, because it needs to replenish its money.”
A GDP strategist estimated that some $750 billion to $800 billion could move out of cash instruments, such as bank deposits and overnight funding transactions with the Fed. That decline in dollar liquidity will get used to buying $800 billion to $850 billion worth of T-bills by the end of September.
“Our concern is that if liquidity, for whatever reason, starts to leave the system, it will create an environment where markets are prone to crashes,” said Alex Lennard, director of investment at global asset manager Ruffer. “That’s where the debt ceiling matters.”
Mike Wilson, equity strategist at Morgan Stanley, agreed. The Treasury bill issuance “will actually suck a lot of liquidity out of the market and could serve as a catalyst for the correction we’ve been predicting,” he said.
However, the liquidity loss is not a given. The issuance of T-bills could be partially absorbed by mutual money market funds, a departure from the overnight reverse repo facility, where market players lend money overnight to the Fed in exchange for government bonds.
In that case, “the impact on broader financial markets would likely be relatively limited,” Daniel Krieter, director of fixed income strategy at BMO Capital Markets, said in a report.
The alternative, with liquidity coming from banks’ reserves, “could have a more measurable effect on risky assets, especially at a time of high uncertainty in the financial sector,” he added.
Some bankers feared that financial markets may not have taken into account the risk of a liquidity leak from banks’ reserves.
The S&P 500 has made significant gains over the past year, while investment-grade and junk bond spreads have narrowed or widened only marginally since January.
“Risk assets probably have not fully priced in the potential impact of the tightening of liquidity in the system from an overabundance of T-bill issuance,” said Scott Schulte, a general manager of Citigroup’s debt capital markets group.
Bankers hoped that the debt ceiling deadlock would be resolved without significant market disruption, but warned that this is a risky strategy.
“Credit markets are pricing in a resolution in Washington, so if that doesn’t come through early next week, we’re likely to see some volatility,” said Maureen O’Connor, global head of the high-value debt syndicate at Wells Fargo.
“That said, many investment-grade companies have avoided this risk, which is why we saw such an active calendar in May,” she added.
(Reporting by Shankar Ramakrishnan, Saeed Azhar, Davide Barbuscia and Laura Matthews; editing by Paritosh Bansal, Megan Davies and Kim Coghill)