After the debt ceiling deal

Good morning. Kate right here. Thanks a lot for having me again at Unhedged whereas Ethan and Rob are off. It was beautiful listening to from you final time, and I’d be eager to get your ideas once more as we speak, particularly about debt ceiling dangers that you just assume aren’t getting sufficient consideration. Electronic mail me: [email protected] 

What occurs after the debt ceiling deal?

Lawmakers in Washington are negotiating a deal to lift the debt ceiling. Republican Home Speaker Kevin McCarthy has met President Joe Biden this week, and Federal Reserve chair Jay Powell has weighed in too. At stake is a US debt default, which can occur if a deal will not be reached by June 1. 

The precise contours of a deal will matter to markets. However I’m additionally interested in what occurs after a decision is reached. Suppose that in every week Congress has raised the debt ceiling and averted a US default. What then?

The US reached its $31.4tn borrowing restrict again in January, and has since been utilizing “extraordinary measures” (ie, digging spare change out of the sofa cushions) to pay its payments. In order quickly as a deal is reached, some huge cash will should be borrowed to replenish the Treasury division’s coffers. Jay Barry, co-head of US charges technique at JPMorgan (who cleverly titled his be aware on the subject “Après moi, le déluge”), has mentioned its estimates are for Treasury to challenge about $750bn in payments within the 4 months following a decision, with roughly $1.1tn within the final seven months of 2023.

Somebody has to pay in money for all these recent Treasuries, sucking liquidity out of the system. Analysts say that this flood of issuance may add pressure to banks and lift borrowing prices because the US financial system continues to sluggish.

Quantitative tightening has already led to an enormous amount of money pulled out of financial institution reserves. A flood of Treasury payments may exacerbate that drain, sufficient that it could drive the Fed to query whether or not it could possibly preserve QT, Barry says. 

The ache isn’t restricted to the bond market. A debt deal will in all probability contain cuts in authorities spending that would curtail financial development and hit shares, says Jake Jolly, head of funding evaluation at BNY Mellon.

“There appears to be a view on the market that there might be a aid rally on the deal. I feel that may be a big mistake. That didn’t occur in 2011. The austerity that got here with that deal was greater than what the market anticipated. In the present day, my concern is that whereas no debt ceiling debate is strictly the identical because the earlier, this one may extra adversely have an effect on markets.”

The constraint on liquidity available in the market from the surge in T-bill issuance can be seemingly a threat for shares. Michael Wilson, fairness strategist at Morgan Stanley, over the weekend warned that “whereas a debt ceiling decision removes a near-term market threat, a fabric dislocation was by no means priced in and the larger threat for markets now could be that elevating the debt ceiling may lower market liquidity primarily based on the sizeable Treasury issuance we anticipate over the six months after it passes”. In different phrases, even an orderly finish to the debt ceiling drama may damage.

Cash market funds — mutual funds that spend money on short-term debt — may assist cushion the blow by absorbing a few of this provide.

Cash market funds have usually had an enormous portion of their holdings in Treasury payments, however that proportion has modified up to now two years as cash funds have more and more come to depend on the Fed’s reverse repo facility. This programme — which lets sure buyers stash money there in a single day — has attracted huge inflows since 2021 as a result of it presents beneficiant returns for no threat. Some $2.3tn is stashed within the RRP each evening. 

A flood of T-bill provide ought to imply decrease costs and better yields, making payments extra aggressive with the RRP for cash market funds, which have lots of money to place to work.

Whereas this could assist, the portions of debt to be issued are huge, and should in the end require a Fed-shaped intervention like, maybe, the top of QT.

Shorts season

Speculative merchants like hedge funds have the most important brief place in two-year Treasury futures on file. You may see the place within the weekly knowledge launched by the Commodity Futures Buying and selling Fee charted beneath:

If this have been a simple brief place, it will be a approach of betting on an increase in two-year yields and a drop in value. As a result of two-year yields transfer with rate of interest expectations, that will counsel speculators have been betting both on extra rate of interest will increase from the Fed or on increased charges for longer.

The CFTC’s knowledge is an mixture and positively captures some merchants who’re making that guess. However buyers and analysts cautioned {that a} bulk of the place is probably going a part of a relative worth commerce, paired with a protracted place in money, which earnings from dislocations between the value of comparable securities within the futures and money markets. It’s a guess on pricing quirks, not charges fundamentals.

The top of charges buying and selling at an enormous US hedge fund, who wasn’t capable of converse on the file, mentioned: “I feel what you’re seeing within the hedge fund numbers will not be a directional guess however a relative worth guess . . . It’s relative worth methods — within the seller and prop group in addition to hedge funds — primarily being brief the futures and lengthy money.”

Shorting two-year Treasuries has been a painful commerce this 12 months. Speculators have been at file shorts in two-year futures proper earlier than the collapse of Silicon Valley and Signature banks. The turmoil at these banks then prompted buyers to purchase two-year Treasuries, betting that the Fed could be compelled to chop rates of interest — and in search of security within the haven Treasury market. The shift into two-year notes caught out hedge funds who have been brief, and compelled them to exit these positions, creating big quantities of volatility available in the market. The swings in value have been sufficiently big to immediate concern from regulators. 

As Ethan and Rob usually say, the height of the tightening cycle is commonly when issues in markets break. That makes this a dangerous time to be in an enormous brief place in part of the market that pulls buyers throughout moments of turmoil, each for its safe-haven high quality, and since it’s the place to precise views on the Fed’s subsequent transfer.

The opposite shorts season

Rob has talked about carrying shorts in passing in his vogue columns, however has by no means addressed the subject head-on. (Coward.) Right here, then, from the FT archives is a bit on whether or not you possibly can put on shorts to the workplace.