Wall Street rally empties $1 trillion Treasury

Finance


(Bloomberg) — With the newly signed debt ceiling deal, the US Treasury is about to trigger a tsunami of new bonds to quickly replenish its coffers. This would be a further outflow to dwindling liquidity as bank deposits would be raided for the payment. And Wall Street warns the market isn’t ready.

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This negative impact could easily trivialize the aftermath of previous disputes over the debt ceiling. The Federal Reserve’s quantitative tightening program is already eroding bank reserves, and wealth managers are hoarding cash in anticipation of a recession.

JPMorgan Chase & Co. strategist Nikolaos Panigirtzoglou expects the Treasury rush to amplify the impact of QT on equities and bonds, slashing the combined performance of the two companies by nearly 5% this year. Citigroup’s macro strategists put forward similar calculations, showing a median 5.4% two-month drop in the S&P 500 with a liquidity drop of this magnitude and a 37 basis point move in high yield bond spreads. indicates that there is a possibility of

The sale, set to begin Monday, will rumble across all asset classes amid claims that funding is already shrinking. JP Morgan estimates that a broad measure of liquidity will fall by $1.1 trillion from about $25 trillion in early 2023.

“This is a very large outflow of liquidity,” Panigirtzoglou said. “We rarely see anything like that. We only see a contraction like this in the case of a severe crash like the Lehman crisis.”

Combined with the Fed’s tightening, liquidity measures will depress by 6% annually, according to JPMorgan’s estimates, as opposed to annual growth for most of the past decade.

In recent months, the United States has resorted to unusual steps to help its own money as leaders quarrel in Washington. With a default narrowly averted, the Treasury is expected to make $1 trillion by the end of the third quarter, according to some Wall Street estimates, starting Monday with multiple Treasury bill auctions totaling more than $170 billion. It plans to start borrowing that it may exceed.

It’s not easy to predict what will happen as billions of people move through the financial system. Short-term Treasury Bills have a variety of buyers, including banks, money market funds, and a broad range of buyers who are broadly classified as “non-bank.” These include household budgets, pension funds and corporate treasuries.

Banks currently have limited demand for treasury bills. That’s because the yields offered are unlikely to compete with the yields available on their own reserves.

But even if banks don’t participate in the Treasury tender, it could still wreak havoc if customers shift from deposits to the Treasury. Citigroup modeled a past episode of bank reserves falling by $500 billion in 12 weeks to estimate what could happen in the coming months.

“Lower bank reserves are usually a headwind,” said Dirk Wheeler, head of global macro strategy at Citigroup Global Markets.

The benignest scenario is supply dominated by money market mutual funds. It is believed that if they buy from their cash pots, the bank reserves will remain intact. They have historically been the most prominent buyers of Treasuries, but have recently stepped back in favor of higher yields from the Fed’s reverse repurchase agreement program.

Then the rest is non-bank. These will be put up for auction at weekly Treasury auctions, not without spillover costs for banks. These buyers are expected to liquidate bank deposits to fund their purchases, exacerbating the capital flight that has led to a shakeout of regional financial institutions and destabilization of the financial system this year.

Saxo Bank A/S fixed-income strategist Altair Spinozzi said it had long been clear that the government was relying more on so-called indirect bidders. “The past few weeks have seen record levels of indirect bidders in Treasury auctions,” she said. “It is likely to absorb a large portion of future issuance as well.”

For now, the relief that the US has avoided a default distracts attention from the looming liquidity aftershock. At the same time, investor excitement over the promise of artificial intelligence has pushed the S&P 500 index to the top of a bull market after his three-week rally. Meanwhile, individual stock liquidity is improving, contrary to the general trend.

But that hasn’t allayed concerns about what usually happens when bank reserves drop significantly. That means stocks will fall, credit spreads will widen, and riskier assets will bear the brunt of the losses.

“It’s not a good time to own the S&P 500,” said Citigroup’s Willer.

Despite the AI-driven rally, equity market positioning remains broadly neutral, with mutual funds and individual investors holding the status quo, Barclays said.

Ulrich Urban, head of multi-asset strategy at Berenberg, said he doesn’t expect an outburst of volatility, with “stocks going down significantly as liquidity dries up.” “Internal market conditions are bad, leading indicators are negative and liquidity is declining. None of this is helping the stock market,” he said.

–With contributions from Sujata Rao, Elena Popina, and Liz Capo McCormick.

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