Is US default delayed? Will the debt bar be raised?

Many on Wall Street are predicting that lawmakers will eventually come to an agreement that will likely prevent a devastating debt default. But that doesn't mean the economy will walk away unscathed, not only because of the heavy standoff, but also as a result of the Treasury Department's efforts to return to business as usual as soon as it can increase its borrowing.

Ari Bergmann, whose firm specializes in hard-to-manage risks, says investors should hedge against the impact of the Washington resolution.

The market veteran means that the Treasury will have to struggle to replenish its dwindling cash buffer in order to maintain its ability to pay its obligations with a flood of Treasury bill sales. The surge in supply, estimated to be worth more than $1 trillion by the end of the third quarter, will quickly drain liquidity from the banking sector, raise short-term funding rates and tighten the screws on the US economy, which is on the brink of recession. According to Bank of America Corp., this will have the same economic effect as a quarter point increase in interest rates.

Higher borrowing costs from the most aggressive Federal Reserve tightening cycle in decades have already taken their toll on some firms and are slowly holding back economic growth. Against this backdrop, Bergmann is especially wary of a possible step by the Finance Ministry to restore cash, seeing the possibility of a significant reduction in bank reserves.

“My main concern is that when the debt limit is resolved — and I think it will be — you will be faced with a very, very deep and sudden liquidity drain,” said Bergmann, founder of New York-based Penso Advisors. “It's not something that's very obvious, but it's something that's very real. And we have already seen that such a drop in liquidity really negatively affects risk markets such as equities and credit.”

As a result, even after Washington overcomes the latest standoff, the dynamics of the Treasury's cash balance, the Fed's portfolio reduction program known as quantitative tightening, and the pain of higher interest rates will all weigh on risky assets as well as the economy. .

With the debt ceiling resolved, the US cash buffer - the Treasury General Account - should soar to $550 billion at the end of June from its current level of about $95 billion - and reach $600 billion in three months, according to the ministry. latest ratings.

The recovery will affect liquidity throughout the financial system because the cash pile acts like the government's checking account with the Fed, sitting on the central bank's balance sheet liabilities.

When the Treasury issues more bills than it technically needs in a given period, its account swells—pulling money out of the private sector and storing it in the department's account at the Fed.

Another important piece of the puzzle is the Fed's buyback agreement, dubbed the RRP, which is where money market funds deposit cash with the central bank overnight at a rate of just over 5%.

$2 trillion

This program - currently over $2 trillion - is also a Fed commitment. Thus, if the Treasury account increases but RRP falls, then there is less reserve leakage.

But Matt King of Citigroup Inc. says the cash funds propensity to hold cash in RRP is likely to continue, which could mean a significant drain on bank reserves as Treasury cash jumps.

And it will happen as major central banks are already pumping out liquidity through aggressive tightening campaigns and efforts to spin up their balance sheets.

“We are moving from a very significant tailwind of global central bank liquidity over the past six months to a likely significant headwind,” said King, global market strategist. “What we are really concerned about is the reserves, which should be reduced. So for now, I'm strongly leaning towards risk aversion."

Priya Mishra of TD Securities fears that reserves will become scarce, disrupting the funding markets that underlie many of Wall Street's deals.

Such deficits “make a big difference because it raises repo rates,” said the firm’s head of global rate strategy. “High repo rates usually lead to high risk. If I'm a hedge fund, my whole business model is based on borrowing money. And not only will there be an increase in the rate, but also that I may not want to lend you.”

This impact on funding markets has, in fact, been seen since the debt ceiling episode of 2017-2018, when the Treasury issued $500 billion of notes in about six weeks.