U.S. debt deal will have limited impact on markets

In what may be seen as a breather for financial markets, U.S. President Joe Biden, along with influential Republican Kevin McCarthy, has reached an interim agreement to alleviate the $31.4 trillion debt ceiling standoff, according to insiders privy to the deliberations.

However, this prospective pact must wade through Congressional approval before early June to avoid a potential and catastrophic, default of the U.S. government.

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Impact on Federal Reserve confidence and market liquidity

Market analysts are optimistic about this development, with KlarityFX director Amo Sahota opining that the deal might provide the U.S. Federal Reserve more confidence to consider further rate hikes.

Regardless, this potential boon for investors may be a fleeting one. Following a successful debt deal, the U.S. Treasury is expected to rapidly replenish its depleted reserves via bond issuance, potentially draining hundreds of billions from the market.

“This will be a relief to the fixed income markets, but the issue of Treasury yields climbing remains unsolved due to anticipated heavy issuance of bonds, notes, and bills in the next few weeks as the U.S. Treasury restocks its cash,” warned Thierry Wizman, Macquarie’s global FX and interest rates strategist.

The successful raising of the debt ceiling is predicted to lead to the issuance of approximately $1.1 trillion in fresh Treasury bills within the next seven months, according to recent estimates by JPMorgan.

This amount, substantial considering the short period, is expected to be issued at current high-interest rates, leading to a further draining of bank reserves.

This could enhance the already prevalent trend of deposit outflows, pressurizing liquidity, and inflating rates on near-term loans and bonds. These developments could burden companies struggling in the current high-interest rate climate.

Liquidity drain and potential market instability

Analysts have raised concerns about the potential impact of this liquidity shift. Ruffer’s investment director, Alex Lennard, warned that an exodus of liquidity could make the markets prone to crashing.

Echoing this sentiment, Morgan Stanley’s equity strategist, Mike Wilson, suggested the Treasury bills issuance could catalyze the correction they have been predicting by drawing liquidity from the marketplace.

Yet, the liquidity drain isn’t a foregone conclusion. Money market mutual funds could partially absorb the T-bill issuance, moving away from the overnight reverse repo facility where market players lend cash overnight to the Fed in exchange for Treasuries.

BMO Capital Markets’ director of fixed income strategy, Daniel Krieter, said that such a scenario could ensure the broader financial markets feel only minimal impacts.

Nevertheless, if the liquidity drain is derived from banks’ reserves, it could potentially affect risk assets, especially in a time of heightened financial sector uncertainty.

There are fears among banking circles that financial markets may have underestimated the risk of a liquidity drain from bank reserves. Investment-grade and junk bonds have seen a positive trend or minimal widening since January, despite the potential liquidity tightening due to a probable surge in T-bill issuance.

As Scott Schulte, a managing director in Citigroup’s debt capital markets group, warned, “Risk assets likely have not fully priced in the potential impact of the tightening of liquidity in the system through an abundance of T-bill issuance.”

Markets hope for a resolution to the debt ceiling stalemate without significant disruptions, but as Maureen O’Connor, global head of high-grade debt syndicate at Wells Fargo, cautioned, it is a risky strategy.

If Washington fails to deliver the anticipated resolution by next week, market volatility could ensue.

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