With the ink barely dry on the debt ceiling deal signed by President Joe Biden, Wall Street braces for impact. The imminent deluge of new US Treasury bonds, primed to replenish the nation’s coffers, is set to exert further strain on the already diminished liquidity as bank deposits are appropriated for the cause. Financial analysts warn that the markets are ill-prepared for this torrent.
The aftershocks of this fiscal maneuver could surpass those of previous debt limit disputes. The Federal Reserve’s quantitative tightening program has gradually chipped away at bank reserves, while money managers, cautious of a looming recession, have opted to stash away cash reserves.
Estimations from JPMorgan Chase & Co’s strategist Nikolaos Panigirtzoglou suggest that this Treasury onslaught could exacerbate the effects of quantitative tightening on stocks and bonds, potentially slicing off almost 5% from their combined performance in 2023.
The impending treasury sales, expected to commence on Monday, will resonate through every asset class as they tap into the already dwindling money supply. JP Morgan’s projections estimate a sharp decline of about $1.1 trillion from the roughly $25 trillion liquidity pool at the start of 2023.
Having skirted a default, the Treasury is poised to embark on a borrowing spree that, according to some Wall Street estimates, could exceed $1 trillion by the end of the third quarter. This massive undertaking kicks off with several Treasury bill auctions on Monday, collectively exceeding $170 billion.
Forecasting the ripple effects as these billions navigate the financial system labyrinth is no mean feat. Prospective buyers for short-term Treasury bills encompass a broad spectrum, including banks, money market funds, and a diverse group of buyers often categorized as “non-banks.” This latter group ranges from households to pension funds and corporate treasuries.
Given the current lackluster yields, banks are likely to demonstrate limited interest in Treasury bills, preferring the returns on their reserves. However, even a bank’s passive stance in the Treasury auctions could trigger turmoil if their clients transition from deposits to treasuries. Citigroup used historical data where bank reserves fell by $500 billion within 12 weeks as a template to approximate the potential outcomes in the months to follow.
In the best-case scenario, money market mutual funds will absorb the supply. These funds, traditionally the most avid buyers of treasuries, have recently shifted their focus towards the more appealing yields offered by the Fed’s reverse repurchase agreement facility. Assuming these funds utilize their cash reserves, bank reserves should remain untouched.
But then there are the “non-banks.” Though these buyers are likely to make appearances at the weekly Treasury auctions, their participation comes at a cost. Expected to liquefy their bank deposits to free up cash for purchases, these buyers could amplify capital flight, exacerbating the financial system’s instability in 2023 and leading to a cull of regional lenders.
For now, relief that the United States has sidestepped default has momentarily overshadowed concerns about potential liquidity shocks. Amid this relief, investor enthusiasm over the burgeoning artificial intelligence prospects has primed the S&P 500 on the verge of a bull market following three weeks of gains. Simultaneously, liquidity for individual stocks has seen a resurgence, deviating from the broader trend.
However, these silver linings have done little to quell market anxieties. Historically, a downturn in bank reserves is usually followed by a stock market fall and widening credit spreads, with riskier assets shouldering the majority of the losses.
What lies ahead for Wall Street and the financial system is a complex interplay of these new bonds with various financial players—banks, mutual funds, non-banks, and more. This impending wave of Treasury bills is more than a matter of federal borrowing; it's a catalyst with the potential to significantly reconfigure the financial markets.
Implications for the real estate and mortgage markets are significant. The pressure on bank reserves might lead to tightened lending standards, making it more difficult for potential homeowners to secure mortgages. Moreover, a downturn in stocks could fuel investors to turn to real estate as a safer investment, driving up property prices. On the other hand, potential instability in the financial system could have a ripple effect on consumer confidence, possibly dampening demand for new homes. The interconnectivity of these markets promises a fascinating, albeit complex, financial dance as the year progresses.