By Shankar Ramakrishnan, Davide Barbuscia, Saeed Azhar and Laura Matthews
(Reuters) – Good news of a tentative deal on the U.S. debt ceiling impasse could quickly turn out to be bad news for financial markets.
US President Joe Biden and Republican in Congress Kevin McCarthy reached a tentative deal on Saturday to raise the federal government’s debt ceiling to $31.4 trillion, two sources familiar with the negotiations said, potentially averting a default economically destabilizing.
But the deal still faces a rocky road to get through Congress before the government runs out of money to pay its debts in early June.
“It will be pretty good for the market,” said Amo Sahota, head of KlarityFX, adding that it could give the US Federal Reserve more reason to feel confident about the rate hike again.
“Although we want to see what the deal looks like,” Sahota added.
While the end of the uncertainty is welcome, the relief that could come from a deal could be a short-lived sugar spike for investors. Indeed, once a deal is struck, the US Treasury is expected to quickly fill its empty coffers with bond issues, sucking hundreds of billions of dollars of cash from the market.
The raising of the cap 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 JPMorgan estimates, a relatively large amount for a such a short period.
This bond issuance, presumably at today’s high interest rates, is seen as depleting banks’ reserves as deposits held by private companies and others shift to more remunerative and relatively safer public debt.
This would accentuate an already widespread trend of deposit outflows, put more pressure on cash or cash available to banks, increase rates on short-term loans and bonds and make funding more expensive for companies already in shock. of a high interest rate. pricing environment.
“There is definitely going to be some relief in the fixed income markets,” said Thierry Wizman, global currency and interest rate strategist at Macquarie.
“But what it doesn’t solve is that across the Treasury curve, yields have been rising recently…in anticipation that there will be a lot of issuance of Treasuries, notes and bills. Treasury in the next few weeks because the US Treasury needs to rebuild its cash flow.”
A BNP strategist estimated that some $750 billion to $800 billion could flow out of cash-like instruments, such as bank deposits and overnight funding transactions with the Fed. This drop in dollar liquidity will be used to purchase $800 billion to $850 billion of Treasury bills by the end of September.
“Our concern is that if liquidity starts to leave the system, for whatever reason, it creates an environment in which markets are prone to crashes,” said Alex Lennard, chief investment officer at the global asset manager. Ruffer. “That’s where the debt ceiling matters.”
Mike Wilson, equity strategist at Morgan Stanley, agrees. Issuance of Treasuries “is actually going to suck a whole lot of liquidity out of the market and could serve as a catalyst for the correction that we expect,” he said.
The drain on liquidity is however not a given. Treasury bill issuance could be partly absorbed by money market mutual funds, moving away from the overnight reverse repo facility, where market participants lend overnight cash to the Fed in exchange for Treasury bills.
In this case, “the impact on broader financial markets would likely be relatively moderate,” Daniel Krieter, director of fixed income strategy, BMO Capital Markets, said in a statement.
The alternative, where the liquidity drain comes from banks’ reserves, “could have a more measurable impact on risky assets, especially at a time of high uncertainty in the financial sector,” he added.
Some bankers said they feared that financial markets had failed to price in the risk of liquidity draining from banks’ reserves.
The S&P 500 rose strongly throughout the year, while spreads on investment grade and junk bonds either tightened or widened slightly from January onwards.
“Risk assets likely haven’t fully priced in the potential impact of liquidity being squeezed into the system by an abundance of Treasuries issuance,” said Scott Schulte, managing director of the company’s capital markets group. Citigroup debt.
Bankers are hoping the debt ceiling impasse will be resolved without significant upheaval in markets, but warn it is a risky strategy.
“Credit markets are pricing in a resolution in Washington, so if this isn’t delivered by early next week, we’re likely to see some volatility,” said Maureen O’Connor, global head of credit. high quality debt syndicate at Wells Fargo.
“Having said that, many higher quality companies have anticipated this risk, which is why we’ve seen such an active May calendar,” she added.
(Reporting by Shankar Ramakrishnan, Saeed Azhar, Davide Barbuscia and Laura Matthews; Editing by Paritosh Bansal, Megan Davies and Kim Coghill)