With the debt ceiling bill passed by the US Congress, the US Treasury can now meet the federal government’s payment obligations, with the market expecting the issuance of US Treasury Bills to surge. However, the Treasury General Account (TGA) has fallen significantly from its year-to-date high of $572.6 billion on January 25. Fig. 1 shows the TGA balance of $48.5 billion as of May 29.
Fig. 1: Treasury General Account balance as of May 29. Source: Refinitiv
That means the TGA will need to rebuild its coffers quickly through a wave of government bond issuance. As of June 8, the US Treasury is targeting an end-of-June cash balance of $425 billion and an end-of-September cash balance of $600 billion.
Deutsche Bank strategist Steven Zeng expects net issuance of $400 billion in June and $500 billion between July and September. JP Morgan sees nearly $1.1 trillion in new U.S Treasury Bills coming to the market over the next seven months. BNP Paribas expects some $800 billion could move out of cash-like instruments, such as bank deposits and overnight funding trades with the Federal Reserve.
The market expects that most of the issuance will be in US Treasury Bills, according to Goldman Sachs. However, the Federal Reserve also happens to be winding down its government bond holdings, unlike in the recent past, when they were big buyers of government debt.
Therefore, the Treasury is likely to set continued high interest rates on new issuances to entice investors to absorb this debt. That might present an attractive proposition for money market funds (MMF) to shift into government debt from the overnight reverse repo facilities, where a majority of their cash is currently deployed.
Brandon Brown, vice president of the Short-Term Interest Rates Trading Desk at Goldman Sachs, predicts that most of the supply will be absorbed by MMFs. They currently have a little bit over $2 trillion parked at the Federal Reserve’s Reverse Repurchase Facility (RRP), so there are enough funds to absorb the incoming supply (Fig. 2).
Fig. 2: Funds in Overnight Reverse Repurchase Agreement. Source: Federal Reserve Bank of St. Louis
For that to happen, US Treasury Bills yield would need to be at least close to, if not higher than, yields offered by RRP. Another risk factor for MMFs to consider is the additional duration risk undertaken when purchasing T-Bills vs. RRPs. With the projection of further rate hikes by the Federal Reserve, the risk-to-reward of owning T-Bill yields relative to RRPs would need to be significantly more attractive for funds to be diverted meaningfully.
As of June 9, the US Overnight Repo Rate was set to 5.05 (Fig. 3), which is lower than the US 1M, 2M, 3M, 4M, 6M, and 1Y T-BILL benchmark rates (Fig. 4).
Fig. 3: Current Overnight Repo Rate. Source: Federal Reserve Bank of St. Louis
Fig. 4: US Short-Term Benchmark Rates. Source: Refinitiv
If MMFs are not the primary marginal buyers of the new supply of U.S Treasury Bills, then the funding may come from banks’ reserves, US corporates, bond funds without access to RRP facilities, and foreign investors.
In the scenario that investors free up cash for US Treasury Bills and deplete banks’ reserves, JP Morgan strategist Nikolaos Panigirtzoglou estimates that the flood of U.S Treasury Bill issuance will compound the effect of quantitative tightening on stocks and bonds, knocking almost 5% off their combined performance this year.
Citigroup strategists estimate a median drop of 5.4% in the S&P 500 over two months. JPMorgan estimates that liquidity will drop by US$1.1 trillion from about US$25 trillion at the end of 2023, noting that this phenomenon is “rarely seen” and only occurs during “severe crashes like the Lehman crisis”. Fig. 5 shows the mean and median S&P 500 returns following a $500 billion drawdown of bank reserves. It is expected that the current levels of the S&P 500 would follow the same trajectory if banks’ reserves were to decrease by that amount once again.
Fig. 5: Historic analysis of previous $500 billion drawdowns in 12 weeks, including August and September 2020 and February and May 2022. Source: Citi Research.
While data from the Federal Reserve shows that deposit flight has slowed down significantly (Fig. 6), an increase in short-term government bond yields to 6% or more could put pressure on banks to raise deposit rates. Failure to do so could result in a surge of deposit flight, stressing vulnerable “community banks” and regional lenders that rely heavily on customer deposits for funding.
Fig. 6: Deposits, All Commercial Banks. Source: Refinitiv
Citi Research has noted that out of the last ten debt ceiling resolutions, seven have resulted in the 2s10s slope steepening one month post-resolution. However, it was noted that before resolution, the curve was significantly steep to start with in most of the resolutions. This time, however, the slope was inverted by 76.40bp on May 30 (Fig. 7).
Fig. 7: US Treasury 2-Year Minus 10-Year Spread. Source: Refinitiv
Given the deep inversion of the yield curve, Citi commented that it would be “challenging for the curve to flatten in line with past episodes of debt ceiling resolutions”.
On the day of the resolution itself, major equity indices such as the Dow Jones Industrial Average, S&P 500, and the Nasdaq Composite rose 1.65%, 1.24%, and 0.94%, respectively, supported by stronger-than-expected jobs growth data. The benchmark 2- and 10-year notes were up at 4.4865% and 3.673%, respectively, as well. As of June 9, the 2 and 10-year benchmarks rose to 4.6125% and 3.7510%, respectively, with the 2-year/10-year (2s10s) steepening from -0.8135% to -0.8615%.
It is inconclusive to ascertain whether the resolution of the debt ceiling issue and the following government debt issuance will have any significant effect on global markets. Investors may be tempted to purchase these issuances given the high yield and risk-free nature of this debt, which would drain liquidity from global markets.
However, if the present assumption that MMFs would absorb a majority of the issuance of US government bonds holds true, then the impact on valuations would be muted. A more sinister outlook would be that the funding to absorb a majority of this issuance would need to come from banks’ reserves, which could weaken regional lenders further and spur another bank run. In addition, analysts believe that the debt ceiling resolution would be immaterial to the Federal Reserve’s interest rate decision at its June 13 meeting.
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