September 22, 2023

Trillion Dollar Treasury Vacuum Coming Ahead of Wall Street Rally

(Bloomberg) — With a new debt ceiling agreement, the US Treasury is poised to unleash a tsunami of new bonds to quickly replenish its treasury. This will be yet another drain on dwindling liquidity as bank deposits are looted to pay for it – and Wall Street warns that markets are not ready.

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The negative impact could easily overshadow the after-effects of previous debt-limit deadlocks. The Federal Reserve’s quantitative tightening program has already eroded bank reserves as asset managers hoarded cash in anticipation of a recession.

JPMorgan Chase & Co. strategist Nikolaos Panigirtzoglou estimates that a deluge of government bonds will amplify QT’s effect on stocks and bonds, driving their combined yields down nearly 5% this year. Citigroup Inc.’s macro strategists provide a similar calculation, where a median drop of 5.4% in the S&P 500 over two months could follow such a massive liquidity reduction, and a 37 basis point shock for high yield credit spreads.

The sales, which begin Monday, will rumble through every asset class as they claim the money supply is already dwindling: JPMorgan estimates that a broad measure of liquidity will fall $1.1 trillion from about $25 trillion at the start of 2023.

“This is a very big liquidity drain,” says Panigirtzoglou. “We have rarely seen anything like this. Only with serious crashes like the Lehman crisis do you see something like contraction.”

It’s a trend that, along with the Fed’s tightening, will push the measure of liquidity down 6% year-over-year, as opposed to the year-over-year growth for most of the past decade, JPMorgan estimates.

The US has relied on extraordinary measures in recent months to help fund itself as Washington leaders bickered. With bankruptcy narrowly averted, the Treasury is set to unleash a wave of borrowing that some Wall Street estimates could reach $1 trillion by the end of the third quarter, starting with several Treasury bill auctions on Monday held in total more than $170 billion.

What happens as the billions work their way through the financial system is not easy to predict. There are several buyers for short-dated Treasury bills: banks, money market funds, and a large number of buyers loosely classified as “non-banks.” These include households, pension funds and corporate treasuries.

Banks currently have little appetite for treasury bills; that’s because the yields offered probably can’t compete with what they can get out of their own reserves.

But even if banks postpone Treasury auctions, a shift from deposits to Treasuries by their clients could wreak havoc. Citigroup modeled historical episodes in which bank reserves fell by $500 billion in a 12-week timeframe to approximate what will happen in the coming months.

“Any fall in bank reserves is typically a headwind,” said Dirk Willer, head of global macro strategy at Citigroup Global Markets Inc.

The best-case scenario is that the supply is swept up by money market funds. It is believed that their purchases, from their own pots of money, would leave bank reserves intact. Historically the most prominent buyers of government bonds, they have recently taken a step back in favor of better yields offered by the Fed’s reverse repo facility.

That leaves everyone: the non-banks. They will show up in the weekly Treasury auctions, but not without additional costs for the banks. These buyers are expected to free up cash for their purchases by liquidating bank deposits, exacerbating a capital flight that has led to a culling of regional lenders and destabilized the financial system this year.

According to Althea Spinozzi, a fixed income strategist at Saxo Bank A/S, the government’s growing reliance on so-called indirect bidders has been apparent for some time. “In recent weeks, we have seen a record number of indirect bidders at U.S. Treasury auctions,” she says. “It’s likely they’ll also absorb a large chunk of upcoming issues.”

For now, relief that the US is avoiding bankruptcy has diverted attention from a looming liquidity aftershock. At the same time, investor excitement about the prospects for artificial intelligence has pushed the S&P 500 to the brink of a bull market after three weeks of gains. Meanwhile, liquidity for individual stocks has improved, against the broader trend.

But that hasn’t allayed fears about what usually happens when bank reserves fall markedly: equities fall and credit spreads widen, with riskier assets taking the brunt of the losses.

“It’s not a good time to hold onto the S&P 500,” said Citigroup’s Willer.

Despite the AI-driven rally, positioning in equities is largely neutral and mutual funds and retail investors remain in place, according to Barclays Plc.

“We think there will be a drop in stocks,” not a volatility explosion “because of the liquidity loss,” said Ulrich Urbahn, head of multi-asset strategy at Berenberg. “We have poor market internals, negative leading indicators and a drop in liquidity, all of which are not supportive for equity markets.”

–With assistance from Sujata Rao, Elena Popina, and Liz Capo McCormick.

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