Wall Street's Rally Is Set For A Trillion-Dollar Treasury Vacuum

The recent signing of a debt ceiling deal by President Joe Biden has set the stage for a significant influx of new bonds from the US Treasury, aiming to replenish its coffers swiftly. However, this move poses a considerable threat to already dwindling liquidity as bank deposits are tapped into to cover the debt, leading Wall Street to express concerns over the preparedness of the markets.

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The potential negative impact of this development could surpass the consequences of previous debt limit standoffs. The Federal Reserve's program of quantitative tightening has already eroded bank reserves, while money managers have been stockpiling cash in anticipation of an economic downturn. 

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Analysts from JPMorgan Chase & Co. and Citigroup Inc. estimate that the surge of Treasuries will compound the effect of quantitative tightening on stocks and bonds, potentially reducing their combined performance by nearly 5% this year. Furthermore, a liquidity drawdown of this magnitude could lead to a median drop of 5.4% in the S&P 500 over two months and a 37 basis-point increase in high-yield credit spreads.

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The sales of these new bonds, slated to commence on Monday, will reverberate across all asset classes, straining an already diminishing money supply. JPMorgan estimates that a broad measure of liquidity will decrease by $1.1 trillion, dropping from approximately $25 trillion at the start of 2023. Nikolaos Panigirtzoglou, a strategist at JPMorgan Chase & Co., emphasizes the significant impact of this liquidity drain, comparing it to severe market contractions like the Lehman crisis. According to JPMorgan's estimations, this trend, coupled with the Federal Reserve's tightening measures, will cause a 6% annualized decline in liquidity, in stark contrast to the annualized growth experienced during most of the past decade.

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As Washington leaders engaged in bickering, the US has resorted to extraordinary measures to fund itself in recent months. The debt ceiling deal brokered between President Biden and House Speaker Kevin McCarthy imposes limits on federal spending for two years and suspends the debt ceiling until the 2024 election. With default narrowly avoided, the Treasury is set to embark on a borrowing spree, projected by some Wall Street estimates to exceed $1 trillion by the end of the third quarter. The spree will commence with several Treasury-bill auctions totaling over $170 billion.

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The consequences of this massive influx of funds into the financial system are challenging to predict. Various buyers, including banks, money-market funds, households, pension funds, and corporate treasuries, participate in short-term Treasury bill purchases. Banks currently exhibit limited appetite for Treasury bills as the yields they offer cannot compete with the returns on their own reserves. However, even if banks abstain from the Treasury auctions, a shift by their clients from deposits to Treasuries could have disruptive effects. Citigroup's analysis, based on historical episodes, suggests that a decline of $500 billion in bank reserves over 12 weeks is a reasonable approximation of what may occur in the coming months.

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Dirk Willer, Head of Global Macro Strategy at Citigroup Global Markets Inc., notes that any decline in bank reserves typically poses a headwind. The most favorable scenario involves money-market mutual funds absorbing the Treasury supply through their own cash reserves, leaving bank reserves unaffected. Historically, money-market mutual funds have been the primary buyers of Treasuries, but recently, they have shown a preference for better yields offered by the Federal Reserve's reverse repurchase agreement facility.

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This leaves the remaining buyers classified as "non-banks." While they will participate in the weekly Treasury auctions, their actions are expected to come at a cost to banks. These buyers are likely to liquidate bank deposits to free up cash for their purchases, exacerbating capital flight, which has already led to the closure of regional lenders and destabilized the financial system this year.

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The growing reliance on "indirect bidders" in Treasury auctions has been evident for some time. These bidders are expected to absorb a significant portion of the upcoming issuances, according to Althea Spinozzi, a fixed-income strategist at Saxo Bank A/S.

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For now, the relief stemming from the US avoiding default has diverted attention away from the potential liquidity aftershock. Simultaneously, investor enthusiasm for the prospects of artificial intelligence has propelled the S&P 500 on the verge of a bull market after three weeks of gains. Moreover, liquidity for individual stocks has shown improvement, defying the broader trend.

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However, concerns persist about the usual consequences of a significant downturn in bank reserves, such as falling stock prices and widening credit spreads, with riskier assets bearing the brunt of the losses. Citigroup's Willer warns that it is not an opportune time to hold the S&P 500. Despite the AI-driven rally, positioning in equities remains broadly neutral, with mutual funds and retail investors maintaining their positions, as reported by Barclays Plc.

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Ulrich Urbahn, Head of Multi-Asset Strategy at Berenberg, predicts a gradual decline in stocks without a volatility explosion due to the ongoing liquidity drain. He highlights unfavorable market internals, negative leading indicators, and a drop in liquidity, all of which do not bode well for stock markets.

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