By Shankar Ramakrishnan, Davide Barbuscia, Saeed Azhar and Laura Matthews
(Reuters) – The good news of a tentative deal on the US debt ceiling impasse could quickly turn into bad news for financial markets.
U.S. President Joe Biden and Republican top congressman Kevin McCarthy on Saturday reached an interim agreement to raise the federal government's $31.4 trillion debt ceiling, two sources familiar with the negotiations said, possibly causing a economically destabilizing default could be averted.
However, it still faces a difficult road to getting the deal through Congress before the administration runs out of money to pay off its debt in early June.
“That's going to be pretty good for the market,” said Amo Sahota, a director at KlarityFX, adding that this could potentially give the Federal Reserve more reason to be confident about raising rates again.
“Although we want to see what the … deal looks like,” Sahota added.
While an end to uncertainty would be welcomed, the relief a deal could bring could be a short-lived sugar high for investors. That's because once a deal is reached, the US Treasury is expected to quickly fill its empty coffers by issuing bonds, sucking hundreds of billions of dollars in cash out of the market.
The cap hike 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 the latest estimates from JPMorgan, a relatively large amount for such a short period of time.
It is observed that this bond issuance, presumably at the current high interest rates, will deplete banks' reserves as deposits from private companies and others are shifted to higher-yielding and relatively safe government bonds.
This would amplify an already prevailing trend of deposit outflows, put pressure on banks' liquidity and cash on hand, push up interest rates on short-term loans and borrowing, and make financing more expensive for companies already suffering from a high interest rate environment.
“There will certainly be some easing in fixed income markets,” said Thierry Wizman, Macquarie's global FX and rates strategist.
“But what that doesn't solve is that yields have been rising along the entire Treasury curve of late…in anticipation that the US Treasury will be issuing lots of Treasury bonds, debentures and bills over the next few weeks that it needs to be cash.” fill up.
One BNP strategist estimated around $750 billion to $800 billion could be withdrawn from cash-like instruments such as bank deposits and overnight funding deals with the Fed. This drop in dollar liquidity will be used to purchase between $800 billion and $850 billion worth of government bonds through the end of September.
“We are concerned that if liquidity drains out of the system for any reason, there will be an environment where markets are in danger of falling,” said Alex Lennard, director of investments at global wealth manager Ruffer. “This is where the debt ceiling comes in.”
Mike Wilson, equity strategist at Morgan Stanley, agreed. The issuance of Treasury bills “will effectively drain a lot of liquidity from the market and could act as a catalyst for the correction we are forecasting,” he said.
However, the outflow of liquidity is not a matter of course. Treasury issuance could be partially absorbed by money market mutual funds and shift away from the overnight reverse repo facility, where market participants lend cash to the Fed overnight in exchange for Treasuries.
In that case, “the impact on broader financial markets would likely be relatively small,” said Daniel Krieter, head of fixed income strategy at BMO Capital Markets, in a report.
The alternative, in which liquidity outflows from banks' reserves, “could have a more measurable impact on risky assets, especially at a time of heightened uncertainty in the financial sector,” he added.
Some bankers said they fear financial markets may not have factored in the risk of liquidity draining from banks' reserves.
The S&P 500 has risen sharply over the year, while investment grade and junk bond spreads have either narrowed or widened only marginally since January.
“Risk assets have likely not fully priced in the potential impact of a glut of T-bill issuance tightening liquidity in the system,” said Scott Schulte, chief executive of Citigroup's Debt Capital Markets group.
Bankers hope the debt ceiling impasse can be resolved without significant market disruption but warn it is a risky strategy.
“Credit markets are pricing in a solution in Washington. So if that doesn't get implemented by early next week, we're likely to see some volatility,” said Maureen O'Connor, global head of Wells Fargo's prime debt syndicate.
“However, many investment-grade companies have pre-empted that 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)