Fan Yu Debt Ceiling Aftermath

Treasury liquidity drain, confounding macro data are new worries

t the risk of sounding like a market curmudgeon, we must warn that the debt-ceiling deal agreement is a double-edged sword.

While the immediate financial risk of a U.S. government default has been averted, a few other consequences resulting from the debt-ceiling increase will likely haunt investors and the U.S. economy in the next few months.

In other words, we should brace for some turmoil in the equity markets.

While the consensus view is that the Federal Reserve will pause its rate increases later this month, the end of the debt-ceiling drama effectively translates to the equivalent of a 25-basis-point hike.

Why? Since the initial U.S. debt ceiling was surpassed earlier this year, the U.S. Treasury has been running down its cash coffers (a.k.a., TGA, or Treasury General Account) to pay its bills. That infusion of liquidity into the financial system has partially fueled the recent U.S. equity market runup led by technology stocks.

With the debt ceiling now lifted, liquidity is about to be drained.

The Treasury will be ramping up the sale of short-term T-bills to replenish the TGA over the coming weeks and months, effectively removing liquidity from the financial system.

This mechanism is going to have a few consequences for investors.

We’ll get the good news out of the way. The fresh supply of T-bills will push up yields, which is good news for income investors looking for places to park short-term cash.

But it’ll have an adverse impact on plenty else.

A surge in T-bill supply and higher yields will cause both consumer and corporate depositors to shift cash into money funds and short-term bills, resulting in a sharp drawdown in bank reserves. This will occur in an environment where banks were already suffering from cash draws from earlier this year.

Current estimates give a range of $1 trillion to $1.5 trillion in new debt sales by the U.S. government, which could suggest a liquidity drain of an amount close to the low end of that range assuming money market funds will move some holdings from reverse repos to T-bills. That’s the equivalent of further quantitative tightening without the Fed having to raise rates.

This liquidity drain is coming in a period where the Fed will likely continue to hike rates in July—assuming it does pause in June—and setting the stage for a very challenging economic environment.

All of the headline macro indicators that the Fed pays attention to are still flashing very hot, at least at first glance.

Inflation is still running hot. The Fed’s all-important core inflation, which excludes food and energy prices, was 4.7 percent in May—more than double the 2 percent target.

All of this is to say that some investors’ belief that June will begin a Fed pivot is a pipe dream. The Fed is likely to continue hiking rates later this year.

While all of this may be necessary, consumers are already feeling the pain. And the pain will worsen going forward.

When we dive down from the 50,000-feet view, the picture on the ground is vastly different than headline economic indicators.

Department store chain Macy’s has noticed that shoppers are tightening their purse strings.

“The US consumer, particularly at Macy’s, pulled back more than we anticipated,” CEO Jeff Gennette said on the company’s quarterly earnings call with analysts on June 1. Gennette shared that consumers are reducing discretionary spending to focus on staples such as food and essentials.

Costco’s executives voiced similar concerns. On its earnings call, the membership-based retailer said that it’s seeing shoppers shift from pricier beef to cheaper meats such as pork and chicken.

Walmart CEO Doug McMillon told investors that the retail giant continues “to gain market share in the grocery category, including with higher income and younger shoppers.” Seeing more wealthy shoppers is great for Walmart, but not a great signal for the broader economy.

While the worst outcome has been averted by the debt-ceiling agreement, investors and consumers are instead now facing a series of bad outcomes.

Thought Leaders