Investors Should Brace for Debt Ceiling Aftermath

Commentary At the risk of sounding like a market curmudgeon, we must warn that the debt-ceiling deal agreement is a double-edged sword. While the immediate financial risk of a U.S. government default has been averted, a few other consequences resulting from the debt ceiling increase will likely haunt investors and the U.S. economy in the next few months. In other words, we should brace for some turmoil in the equity markets. While the consensus view is that the Federal Reserve will pause its rate hike later this month, the end of the debt-ceiling drama effectively translates to the equivalent of a 25-basis-point hike. Why? When the initial U.S. debt ceiling was surpassed earlier this year, the U.S. Treasury has been running down its cash coffers (a.k.a. TGA, or Treasury General Account) since then to pay its bills. That infusion of liquidity into the financial system has partially fueled the recent U.S. equity market runup led by technology stocks. With the debt ceiling now lifted, liquidity is about to be drained. The Treasury will be ramping up the sale of short-term T-bills to replenish the TGA over the coming weeks and months, effectively removing liquidity from the financial system. This mechanism is going to have a few consequences for investors. We’ll get the good news out of the way. The fresh supply of T-bills will push up yields, which is good news for income investors looking for places to park short-term cash. But it’ll have an adverse impact on plenty else. A surge in T-bill supply and higher yields will cause both consumer and corporate depositors to shift cash into money funds and short-term bills, resulting in a sharp drawdown in bank reserves. This will occur in an environment where banks were already suffering from cash draws from earlier this year. Current estimates give a range of $1 to $1.5 trillion in new debt sales by the U.S. government, which could suggest a liquidity drain of an amount close to the low end of that range assuming money market funds will move some holdings from reverse repos to T-bills. That’s the equivalent of further quantitative tightening without the Fed having to raise rates. Bank of America’s chief investment strategist Michael Hartnett suggested in a recent note that global liquidity is set to “collapse more than $1 trillion next 3-4 months” from a combination of central bank quantitative tightening and replenishment of Treasury TGA. Other experts agree. TS Lombard Chief U.S. Economist Steve Blitz recently wrote to clients that the Treasury’s cash policy will pivot from adding 3 percent of GDP in the last five months to subtracting around 10 percent of GDP from the financial markets in the next three. This liquidity drain is coming in a period where the Fed will likely continue to hike rates in July—assuming it does pause in June—and setting the stage for a very challenging economic environment. All of the headline macro indicators that the Fed pays attention to are still flashing very hot, at least at first glance. The May jobs report was a blowout on the surface, with the Bureau of Labor Statistics reporting that nonfarm payrolls surged past 330,000. But those figures are skewed higher by the bureau’s assumptions on net business formations. There’s also a divergence forming in the jobs report, which is made up of two separate surveys: one of households, which indicates unemployment, and one of businesses, which indicates wages and payroll numbers. The household survey showed that people are having a very hard time landing jobs, while the business survey showed that payroll numbers are increasing, especially in roles labeled as “non-management.” Inflation is still running hot. The Fed’s all-important core inflation, which excludes food and energy prices, was 4.7 percent in May—more than double the 2 percent target. All of this is to say that some investors’ belief that June will begin a Fed pivot is a pipe dream. The Fed is likely to continue hiking rates later this year. While all of this may be necessary, consumers are already feeling the pain. And the pain will worsen going forward. When we dive down from the 50,000-feet view, the picture on the ground is vastly different than headline economic indicators. Department store chain Macy’s has noticed that shoppers are tightening their purse strings. “The US consumer, particularly at Macy’s, pulled back more than we anticipated,” CEO Jeff Gennette said on the company’s quarterly earnings call with analysts on June 1. Gennette shared that consumers are reducing discretionary spending to focus on staples such as food and essentials. Target CEO Brain Cornell told reporters earlier in May that consumers are focusing on “household essentials and food and beverage items, and they’re shopping more cautiously when it comes to all things discretionary.” Costco’s executives voiced similar concerns. On its earnings call, the membership-based retailer said that it’s seeing shoppers shift from pri

Investors Should Brace for Debt Ceiling Aftermath

Commentary

At the risk of sounding like a market curmudgeon, we must warn that the debt-ceiling deal agreement is a double-edged sword.

While the immediate financial risk of a U.S. government default has been averted, a few other consequences resulting from the debt ceiling increase will likely haunt investors and the U.S. economy in the next few months.

In other words, we should brace for some turmoil in the equity markets.

While the consensus view is that the Federal Reserve will pause its rate hike later this month, the end of the debt-ceiling drama effectively translates to the equivalent of a 25-basis-point hike.

Why? When the initial U.S. debt ceiling was surpassed earlier this year, the U.S. Treasury has been running down its cash coffers (a.k.a. TGA, or Treasury General Account) since then to pay its bills. That infusion of liquidity into the financial system has partially fueled the recent U.S. equity market runup led by technology stocks.

With the debt ceiling now lifted, liquidity is about to be drained.

The Treasury will be ramping up the sale of short-term T-bills to replenish the TGA over the coming weeks and months, effectively removing liquidity from the financial system.

This mechanism is going to have a few consequences for investors.

We’ll get the good news out of the way. The fresh supply of T-bills will push up yields, which is good news for income investors looking for places to park short-term cash.

But it’ll have an adverse impact on plenty else.

A surge in T-bill supply and higher yields will cause both consumer and corporate depositors to shift cash into money funds and short-term bills, resulting in a sharp drawdown in bank reserves. This will occur in an environment where banks were already suffering from cash draws from earlier this year.

Current estimates give a range of $1 to $1.5 trillion in new debt sales by the U.S. government, which could suggest a liquidity drain of an amount close to the low end of that range assuming money market funds will move some holdings from reverse repos to T-bills. That’s the equivalent of further quantitative tightening without the Fed having to raise rates.

Bank of America’s chief investment strategist Michael Hartnett suggested in a recent note that global liquidity is set to “collapse more than $1 trillion next 3-4 months” from a combination of central bank quantitative tightening and replenishment of Treasury TGA.

Other experts agree. TS Lombard Chief U.S. Economist Steve Blitz recently wrote to clients that the Treasury’s cash policy will pivot from adding 3 percent of GDP in the last five months to subtracting around 10 percent of GDP from the financial markets in the next three.

This liquidity drain is coming in a period where the Fed will likely continue to hike rates in July—assuming it does pause in June—and setting the stage for a very challenging economic environment.

All of the headline macro indicators that the Fed pays attention to are still flashing very hot, at least at first glance.

The May jobs report was a blowout on the surface, with the Bureau of Labor Statistics reporting that nonfarm payrolls surged past 330,000. But those figures are skewed higher by the bureau’s assumptions on net business formations.

There’s also a divergence forming in the jobs report, which is made up of two separate surveys: one of households, which indicates unemployment, and one of businesses, which indicates wages and payroll numbers. The household survey showed that people are having a very hard time landing jobs, while the business survey showed that payroll numbers are increasing, especially in roles labeled as “non-management.”

Inflation is still running hot. The Fed’s all-important core inflation, which excludes food and energy prices, was 4.7 percent in May—more than double the 2 percent target.

All of this is to say that some investors’ belief that June will begin a Fed pivot is a pipe dream. The Fed is likely to continue hiking rates later this year.

While all of this may be necessary, consumers are already feeling the pain. And the pain will worsen going forward.

When we dive down from the 50,000-feet view, the picture on the ground is vastly different than headline economic indicators.

Department store chain Macy’s has noticed that shoppers are tightening their purse strings. “The US consumer, particularly at Macy’s, pulled back more than we anticipated,” CEO Jeff Gennette said on the company’s quarterly earnings call with analysts on June 1.

Gennette shared that consumers are reducing discretionary spending to focus on staples such as food and essentials.

Target CEO Brain Cornell told reporters earlier in May that consumers are focusing on “household essentials and food and beverage items, and they’re shopping more cautiously when it comes to all things discretionary.”

Costco’s executives voiced similar concerns. On its earnings call, the membership-based retailer said that it’s seeing shoppers shift from pricier beef to cheaper meats such as pork and chicken. That is a common substitution by consumers during previous recessions.

Walmart CEO Doug McMillion told investors that the retail giant continues “to gain market share in the grocery category, including with higher income and younger shoppers.” Seeing more wealthy shoppers is great for Walmart, but not a great signal for the broader economy.

While the worst outcome has been averted by the debt-ceiling agreement, investors and consumers are instead now facing a series of bad outcomes.