the massive issuance of debt in the US threatens to dry up the stock market and precipitate the recession

The final agreement on the debt ceiling in the US has been a breather for global financial markets. The White House and the GOP-controlled House have reached an agreement on the debt ceiling just days before the dreaded ‘X date’, when the Treasury was expected to run out of funds. Undoubtedly, the news represents a boost for the markets and the economy in the very short term avoid the tragedy. But the return of the US Treasury, which has not issued a dollar since the beginning of the year -because reached the debt ceiling of 31.4 trillion dollars in January of this year-, to the markets, it will not be easy for the markets and the economy to digest: pay attention to the effect crowding out.

The problems for the US market and economy have not ended with the agreement in principle for the debt ceiling. In the short term, from a financial markets perspective, risk appetite should return. But the truth is that there is a risk of unexpected tensions due to the lack of liquidity that will cause the Treasury to return to the debt market (the Treasury will return to the market with large issues that need large portions of liquidity).

“In the medium-short term, the US stock market seems to ignore or show complacency in the face of a potential significant liquidity drain following the agreement to extend the debt ceiling,” says Kelvin Wong, an analyst at Oanda. The risk is that there will be a effect crowding out flash of lightning. The Federal Government is going to issue a lot of debt in a short time, displacing, a priori, to the private sector. The markets will suffer the impact of this movement.

He effect crowding outAccording to macroeconomic theory, the crowding-out effect or crowding-out effect occurs when the public sector increases its spending through financing (issuing debt), while the economy operates close to full performance. This effect arises because the demand for financing and labor generated in the public sector will naturally reduce the availability of these same resources in the private sector.

That is to say, if in the market there is a certain amount of savings available for investment and the State covers a large part of that savings by issuing more debt, companies will be forced to pay a higher interest rate if they want to compete to attract such savings, since government debt is considered a ‘risk-free’ asset and is much more liquid than corporate debt. In this way, an expulsion or displacement effect is produced, which is suffered above all by companies and families that need financing.

“One thing is certain: in the coming months, the US Treasury will issue hundreds of billions of new bonds to recharge its coffers. Assuming that the US Federal Reserve does not intervene by ‘monetizing’ (buying) the increase in the debt of the US government, the Treasury issue will act as a significant loss of liquidity for other markets,” Gavekal Research warns in a note sent to its clients on Monday.

It seems “likely that the increasing weight of the leviathan of the US government in the economy and the effect crowding out (displacement effect) generate higher yields. Given the positive correlation between US Treasury bonds and stocks, this promises to be a major hurdle for markets,” they warn from the same firm.

Once the deal is approved, the next step for the US Treasury will be to increase the issuance of Treasury bills (T-bills) to quickly bolster its cash reserves, which have been depleting as the Treasury had to meet its obligations to creditors without being able to issue new debt. As of May 25, the US Treasury’s operating cash balance fell to US$38.84 billion, its lowest level since September 2017, according to data from Oanda.

Therefore, the US Treasury needs to replenish its coffers through a total issuance of about US$1 trillion in Treasury bills in the second half of 2023, which could be absorbed, in part, by reserves. from banks through deposits (deposits would suffer a greater fall than they have already experienced) or through monetary investment funds, in the best of cases (here the impact on the markets would be less). In the past two weeks, liquidity and financial conditions have already started to tighten, as reflected in several key indicators.

How would a major drought affect the market?

A BNP strategist estimates that between $750 and $800 billion could come from instruments similar to liquidity, such as bank deposits and overnight financing operations with the Federal Reserve. This decrease in the liquidity of the dollar will be used to buy Treasury bills until the end of September, as revealed by the agency Reuters. “Our concern is that if liquidity starts to leave the system, for whatever reason, this creates an environment where markets are prone to crash,” said Alex Lennard, chief investment officer at global asset manager Ruffer. “That’s where the debt ceiling matters.”

Mike Wilson, an equity strategist at Morgan Stanley, agreed. The issuance of Treasury bills “will effectively absorb a lot of market liquidity and may serve as a catalyst for the correction we have been forecasting,” he says.

Possible ‘drought’ in other market segments

The torrential rain of emissions means leaving other corners of the market dry, leave them without liquidity. The lack of liquidity is a big problem for the stock market and for the credit markets. “There will be a very, very deep and sudden liquidity drain,” says Ari Bergmann, founder of Penso Advisors. Basically, if US fixed income needs buyers, the money has to come from somewhere. The normal thing is that it leaves the most illiquid markets such as variable income and the bank flows themselves.

Since the beginning of the year, the Treasury has not issued a dollar, which has caused a historic opportunity for investors with the bills reaching 7%. Until the situation is balanced again, the money is going to fly towards placements, including that of the banks themselves. Why allocate liquidity to loans, when they can reinforce capital and balance at a bargain price. The dark side is that the economy will run out of the credit boost.

“There will be a knee-jerk reaction in Treasury bills as this part of the market has borne the brunt of the punishment,” they explain from Wisdomtree Investments. Portfolios and balance sheets have endured a plummeting drop in the value of bills, now we must take advantage of the fact that they must rise with new issues. According to Bank of America, the impact of raising Treasury reserves at full throttle will be the same as raising interest rates another quarter point.

Another brake on the economy?

The agreement on the debt ceiling will put another brake on the economy that has been reeling for some time the biggest rate hike in more than two decades and the credit reduction.

The US economy has already experienced a good slowdown in the start of the year and that was still counting on the boost of federal spending. If the GDP grew by 1.3% annualized, half a point was contributed by public consumption. The consensus of economists from Bloomberg it points to a 65% probability that the country will enter a recession next year.

Automatically, the agreements on spending to increase the debt ceiling mean cuts in the forecast models of economists. “Fiscal policy from now on will be tighter, while monetary policy will be even tighter,” warns Diane Swonk, chief economist at KPMG. Despite the fact that Fed has announced a pause in rate hikesthe market is already beginning to discount increases of 25 basis points for the next meeting on July 25. “Both policies restrict growth and feed on each other,” the analyst points out.

The spending cut measures will begin to be applied at the beginning of October and will come at the worst possible time. According to panelists from Bloombergthe GDP will register negative rates in the third and last quarters.