A trillion dollar Treasury vacuum looms before the Wall Street rally

(Bloomberg) – With a debt ceiling agreement freshly signed, the US Treasury is about to unleash a tsunami of new bonds to quickly replenish its coffers. This will put further strain on dwindling liquidity as bank deposits are looted to pay for it – and Wall Street is warning that markets are not yet ready.

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The negative impact could easily dwarf the aftermath of previous debt ceiling standoffs. The Federal Reserve's quantitative tightening program has already eroded banks' reserves, while money managers have hoarded cash in anticipation of a recession.

JPMorgan Chase & Co. strategist Nikolaos Panigirtzoglou estimates that a flood of government bonds will amplify the impact of the QT on equities and bonds, dragging down their overall performance by almost 5% this year. Macro strategists at Citigroup Inc. propose a similar math, suggesting that a 5.4% average decline in the S&P 500 over two months could follow a liquidity decline of that magnitude and a 37 basis point rise in high yield spreads.

The selling, set to begin Monday, will impact all asset classes as they draw on an already shrinking money supply: JPMorgan estimates liquidity will fall by $1.1 trillion broadly, from about $25 trillion dollars at the beginning of 2023.

“This is a very big loss of liquidity,” says Panigirtzoglou. “We've rarely seen anything like this. Something like a decline can only be observed in the case of serious crashes such as the Lehman crisis.”

It's a trend that, combined with Fed tightening, will see liquidity fall by 6% annually, in contrast to annual growth for most of the last decade, estimates JPMorgan.

The US has relied on extraordinary measures to fund itself over the past few months as leaders squabble in Washington. With the default narrowly averted, the Treasury will launch a wave of borrowing that Wall Street estimates could top $1 trillion by the end of the third quarter, beginning with multiple Treasury auctions on Monday that totaled more than amount to US$170 billion.

What will happen when the billions flow through the financial system is not easy to predict. There are a variety of buyers for short-term Treasury bills: banks, money market funds, and a wide range of buyers who are broadly classified as “non-banks.” This includes households, pension funds and corporate funds.

Banks' appetite for Treasury bills is currently limited; That's because the returns on offer probably can't compete with those they can generate from their own reserves.

But even if banks suspend government bond auctions, a shift of deposits into government bonds by their customers could have devastating consequences. Citigroup has modeled historical episodes of bank reserves falling by $500 billion over 12 weeks to estimate what will happen in the months that follow.

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

The most benign scenario is that the supply of money market mutual funds becomes inundated. It is understood that their purchases from their own coffers would leave bank reserves intact. Although they have historically been the most significant buyers of government bonds, they have recently backed down in favor of the better yields offered by the Fed's reverse repurchase facility.

That leaves the rest: the non-banks. They will show up at the weekly Treasury auctions, but not without consequential costs for the banks. These buyers are expected to free up cash for their purchases by liquidating bank deposits, fueling the capital flight that has isolated regional lenders this year and destabilized the financial system.

According to Althea Spinozzi, pensions strategist at Saxo Bank A/S, the government's growing reliance on so-called indirect bidders has been evident for some time. “In the past few weeks, we've seen a record number of indirect bidders at US Treasury auctions,” she says. “It is likely that they will also absorb a large part of the emissions to come.”

For now, relief that the US has avoided a default has drawn attention away 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 cusp of a bull market after three weeks of gains. Meanwhile, the liquidity of individual stocks has improved, bucking the general trend.

But that hasn't allayed fears, which usually happens when there's a sharp fall in bank reserves: stocks fall and credit spreads widen, with riskier assets bearing the brunt of the losses.

“It's not a good time to own the S&P 500,” said Willer of Citigroup.

According to Barclays Plc, despite the AI-driven rally, positioning in equities is broadly neutral, with mutual funds and retail investors unchanged.

“We assume that the outflow of liquidity will lead to a drastic decline in share prices and not to an explosion in volatility,” says Ulrich Urbahn, Head of Multi-Asset Strategy at Berenberg. “We have poor market internals, negative leading indicators and a drop in liquidity, none of which is very supportive for equity markets.”

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

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