Last week there was a big drop in the US federal government’s account at the Fed (the Treasury General Account, or TGA for short). The latest figures show a TGA balance of only $57B, which probably means that the government will run out of money within the next three weeks unless a deal is made to raise or suspend the Debt Ceiling.
Given the lack of fear recently evident in the financial markets, with risk-off assets such as gold doing relatively poorly and signs of aggressive bullish speculation in parts of the stock market, it appears that most market participants expect a deal to be done very soon. While that’s definitely possible, it’s far from a foregone conclusion. Moreover, what comes after a Debt Ceiling deal will not favor the stock market.
What comes after a Debt Ceiling deal will be a flood of new government debt issuance to replenish the TGA and make the payments that were postponed during the preceding months. To be more specific, based on information provided by the Treasury, there will be net new debt issuance of more than $700B during the three months following a deal.
This will drain liquidity from the financial markets unless it is accompanied by money leaving the Fed’s Reverse Repo (RRP) program. For instance, if the government were to increase its total debt by $750B after a deal and $500B of the new debt were purchased by MMFs using funds presently held in the RRP program, then the net liquidity drain would only amount to $250B.
Currently, therefore, there are two big unknowns. The first is the timing of a political deal to raise the Debt Ceiling, and the second is the proportion of the ensuing flood of new debt that will be offset — in terms of the effect on financial market liquidity — by money coming out of RRPs.
With regard to the timing question, there are two main scenarios.
The first is that a deal will be done within the next three weeks, thus avoiding a partial shutdown of the government. As mentioned above, this currently appears to be the general expectation. We suspect that if it comes to pass, it will lead to short-lived (1-week maximum) moves to the upside in the stock market and downside in the gold and T-Bond markets, followed by reversals as other issues, including an imminent recession and the coming flood of new government debt, move to center-stage.
The second scenario is that the political negotiations will drag on until a deal is forced upon the two negotiating parties by extreme weakness in the stock market. Under this scenario, a deal could be 2-3 months away. Even though the TGA balance probably will drop to almost zero within three weeks, this sort of delay in striking a deal is possible because of the corporate tax payments that are due on 15th June and the additional special measures that could become available to the Treasury at the end of June. In addition to substantial stock market weakness and a partial government shutdown, likely ramifications of this scenario include a large rise in the gold price.
What happens with the US government’s Debt Ceiling will have a big influence on the paths taken by the major financial markets over the next three months, but our short-term assessments of risk and reward do not hinge on when/how the Debt Ceiling issue is resolved. Regardless of whether we get the first scenario or the second scenario or something in between, the outlook for the next three months is bearish for the S&P 500 Index, bullish for gold, and bullish for the T-Bond.