(Bloomberg) — With a debt ceiling deal fresh from signing, the US Treasury Department is about to unleash a wave of new bonds to quickly refill its coffers. This will be another drain on dwindling liquidity as bank deposits are stormed out to pay for it – and Wall Street warns that markets are not ready.
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The negative impact can easily dwarf the after effects of past confrontations over the debt limit. The Federal Reserve’s program of quantitative tightening has already eroded banks’ reserves, while money managers have been hoarding liquidity in anticipation of a recession.
Nikolaos Panegirzoglou, strategist at JPMorgan Chase & Co., estimates that the influx of Treasuries will double QT’s impact on stocks and bonds, reducing their combined performance by about 5% this year. Strategists for Citigroup Inc. offer a similar differential calculation, showing an average decline of 5.4% in the S&P 500 over two months could follow a liquidity drawdown of this magnitude, and 37 basis points for high-yield credit spreads.
The sales, set to begin Monday, will fire in every asset class as it claims the money supply is already shrinking: JPMorgan estimates a broad measure of liquidity will drop $1.1 trillion from about $25 trillion at the start of 2023.
“This is a huge drain on liquidity,” says Panigirzoglu. We’ve rarely seen anything like this. Only in serious crashes like the Lehman crisis do you see something like this deflation.”
It’s a trend that, along with Fed tightening, will push the liquidity gauge down at an annual rate of 6%, in contrast to annual growth for most of the past decade, JPMorgan estimates.
The United States has been counting on extraordinary measures to help finance itself in recent months as leaders have bickered in Washington. With default narrowly avoided, the Treasury will begin a borrowing spree that by some Wall Street estimates could reach $1 trillion by the end of the third quarter, starting with several Treasury bill auctions on Monday totaling more than $170 billion.
It is not easy to predict what happens when billions make their way through the financial system. There are many buyers of short-term T-bills: banks, money market funds and a wide variety of buyers loosely classified as “non-banks”. These include households, pension funds, and corporate treasuries.
Banks have a limited appetite for T-bills at the moment; That’s because the returns offered are unlikely to be able to compete with what they can get from their own reserves.
But even if banks quit treasury auctions, a shift from deposits to treasury bills by their customers could lead to chaos. Citigroup modeled historical episodes where bank reserves fell by $500 billion in a 12-week period to approximate what would happen over the following months.
Dirk Wheeler, head of global macro strategy at Citigroup Global Markets Inc.
The most benign scenario is that supply is swept away by money market mutual funds. Presumably their purchases, from their cash receptacles, would leave the banks’ reserves untouched. Historically, the most prominent buyers of Treasuries have recently backed out in favor of better yields offered from the Fed’s reverse repo facility.
That leaves everyone: non-banks. They will be present at the weekly Treasury auctions, but not without a surcharge to the banks. Those buyers are expected to free up cash for their purchases by liquidating bank deposits, exacerbating the capital flight that has culled regional lenders and destabilized the financial system this year.
The government’s increasing reliance on so-called indirect bidders has been evident for some time, according to Althea Spinozzi, fixed income analyst at Saxo Bank A/S. “In the past few weeks, we’ve seen a record level of indirect bidders during US Treasury auctions,” she says. “They’ll probably absorb a good portion of the upcoming releases, too.”
For now, the relief of the US about avoiding a default has deflected attention from any impending liquidity aftershock. Meanwhile, investor excitement about the prospects for artificial intelligence has put the S&P 500 on the cusp of a bull market after three weeks of gains. Meanwhile, liquidity for individual stocks has been improving, bucking the broader trend.
But that has not allayed concerns about what usually happens when there is a significant drawdown in banks’ reserves: stocks fall and credit spreads widen, with riskier assets bearing the brunt of losses.
“It’s not the time to hold the S&P 500,” says Citigroup’s Wheeler.
Despite the AI-driven rally, equity positioning is broadly neutral with mutual funds and retail investors staying where they are, according to Barclays Plc.
“We think there will be a grind in stocks,” says Ulrich Urbahn, head of multi-asset strategy at Berenberg, “and not an explosion of volatility “due to a drain on liquidity.” “We have bad internal market indicators, negative leading indicators and a drop in liquidity, all of which are not supportive of stock markets.”
— With assistance from Sujata Rao, Elena Popina, and Liz Capo McCormick.
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