Authored by Simon White, Bloomberg macro strategist,
The prospect of Federal Reserve rate cuts in the near term will be back on the agenda as the debt-ceiling impasse causes a further tightening in financial and credit conditions.
Hot on the heels of the banking crisis is the market’s next preoccupation: the debt ceiling. Until the political gridlock is broken, the US is ineluctably moving toward “X-Day”: the day when the ceiling is reached, all “extraordinary measures” have been exhausted, and the Treasury is no longer able to pay its obligations.
There is never a good time for the US to be at risk of running out of money, but now is especially unwelcome. Credit conditions and velocity were already tightening in the wake of SVB’s bankruptcy. The prospect of a heated political drama that’s set to go to the wire will only accelerate these trends and raise the probability of an early Fed cut, i.e. before the market’s current expectation of December.
Tracking the evolution of reserves, taxes and bank deposits will be crucial to understanding the risks from the looming debt ceiling.
The two main scenarios are:
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More taxes are received than anticipated, which will push back X-Day. However, this will put extra strain on reserves through a drop in bank deposits, where growth has fallen to a 40-year low
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Less taxes are paid than expected and this brings forward X-Day, leaving less time to reach a political solution to raise the ceiling
So far it looks like the latter of these is transpiring, with April non-withholding tax receipts a quarter lower than their five-year average.
The disappointing inflow to the Treasury’s coffers has prompted Goldman Sachs to estimate that X-Day could occur as soon as early June.
June may even prove conservative, given that very weak leading indicators point to tax-revenue growth continuing to fall and potentially soon contracting.
This should mean less pressure on bank deposits and thus reserves – but it may not be enough. Reserves are already very stressed, with their “impulse”, i.e. the change in their change, having just dropped precipitously. This points to weaker equities and tighter financial conditions even without higher-than-expected tax payments.
Worsening liquidity conditions and significant event risk coming ever closer is a decidedly negative set of circumstances.
Yet despite this, there seems to be a general consensus that
a) the debt ceiling will be avoided; and
b) the uncertainty in the run up to X-Day is unlikely to have a notable market impact.
Both views are complacent.
On the first, nobody knows for sure if the US will avoid the debt ceiling becoming binding, but the political parties are further apart than they were in prior debt-ceiling episodes, so it is perhaps wishful thinking there will be an early resolution. And there is a greater – even if it is still small – chance that no agreement at all is reached.
On the second outlook, the economic and financial backdrop is very different today than it was in 2011 and 2013, the last two times the debt ceiling was a live issue:
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Reserves were rising as QE, not QT, was the prevailing Fed policy;
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The RRP facility did not exist in its present form; and
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The Treasury’s account at the Fed (TGA) was on average much lower than it is today.
In 2011 and 2013 we did not get a significant rise in longer-term yields. However, in both cases the Fed was not contracting its balance sheet. Fed reserves were rising in the run-up to the resolution date as the Fed bought Treasuries, unlike today where its portfolio of USTs is contracting.
There is no guarantee longer-term yields will not flare up this time. This would further tighten credit conditions, which are already suffering as primarily smaller banks pull back on lending in the aftermath of SVB’s failure.
Some shorter-term bill yields have already risen to reflect higher default risk. (Although the Treasury would not have to default on bonds, it would have to so on bills given they are issued below par, but paid back at par, leaving a capital mismatch. Bonds are issued and redeemed at par).
This will be a further incentive for money-market funds to use the RRP, which is a drain on reserves and thus velocity.
The RRP currently sits a smidgen below its all-time high at $2.67 trillion and shows no signs of falling. Reserves are also being drained by the TGA, which is rising as taxes are received.
The debt ceiling – coming in the wake of banking stress and a slowing economy – may just be the proverbial straw that breaks the camel’s back. Even if this does not lead to an actual earlier-than-expected rate cut from the Fed, market pricing is likely to soon reflect this likelihood as the political drama heats up. In other words, two-year yields look like they have little upside above 4.20%-4.30%, but plenty of downside.
Tyler Durden
Tue, 04/25/2023 – 12:20
