"Effective 25 Basis Point Rate Hike"

Once an agreement is reached, the U.S. government may frantically exhaust trillions of dollars in liquidity, an effect comparable to another 25 basis point rate hike, and it could even affect the Federal Reserve's quantitative tightening plan...

Behind the market's concern about the prospect of a historic default in the United States lies a less discussed risk: what happens after an agreement is reached to resolve the debt ceiling deadlock.

Many on Wall Street had previously anticipated that lawmakers would eventually reach an agreement to avoid a catastrophic debt default, even at the last minute. However, this does not mean that the U.S. economy will emerge unscathed, as the damage caused by the debt ceiling deadlock, in addition to the consequences of the Treasury's return to normal operations after it can increase borrowing, will also harm the U.S. economy.

Ari Bergmann, the founder of New York-based Penso Advisors, whose company specializes in managing difficult risks, believes that investors should hedge against the risks associated with Washington reaching an agreement on the U.S. debt ceiling.

Bergmann's point is that once the debt ceiling issue is resolved, the Treasury will need to replenish its dwindling cash cushion by selling a large number of Treasury bills to maintain its ability to pay its debts.

It is estimated that by the end of the third quarter, the supply of Treasury bills will far exceed $1 trillion, which will quickly deplete the liquidity of the banking industry, leading to an increase in short-term financing rates and tightening the U.S. economy at a time when it is on the brink of recession. According to Bank of America estimates, this will have the same economic impact as a 25 basis point rate hike.

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After the Federal Reserve implemented the most aggressive tightening cycle in decades, rising borrowing costs have already affected some businesses and are slowly suppressing economic growth. Against this backdrop, Bergmann is particularly concerned that the Treasury will eventually take action to rebuild its cash reserves, and he believes that bank reserves may be significantly reduced as a result. He said:

"I am more worried that when the debt ceiling issue is resolved, there will be a very, very severe and sudden loss of liquidity. This is not very obvious, but it is very real. We have experienced this before, and a decrease in liquidity does indeed have a negative impact on risk markets such as stocks and credit."

As a result, even after Washington has weathered the recent deadlock, the dynamics of the Treasury's cash balance, the Federal Reserve's quantitative tightening plan, and the pain of rising policy interest rates will all put pressure on risk assets and the economy.

According to the latest estimates from the Treasury, after the debt ceiling is resolved, the U.S. government's cash reserves, the Treasury General Account (TGA), will soar from the current $95 billion to $550 billion by the end of June and reach $600 billion three months later.The rebound of this account will affect the liquidity of the entire financial system, as the Treasury General Account (TGA) is a liability on the Federal Reserve's balance sheet, similar to bank reserves and notes. To balance the Federal Reserve's assets and liabilities, a decrease in the TGA will lead to an increase in bank reserves, which could increase lending or investment in the broader economy or market, that is, inject liquidity into the financial system.

The TGA account swells when the Treasury issues more bills than its technical needs over a period of time, which is equivalent to extracting cash from the private sector, leading to a decrease in liquidity in the financial system.

Another important part of this puzzle is the Federal Reserve's Reverse Repurchase Agreement (RRP) tool, which allows money market funds to deposit their cash overnight at the Federal Reserve at a rate slightly above 5%.

Can the $2 trillion in money funds assist?

The current RRP of over $2 trillion is also a liability of the Federal Reserve. Therefore, if the Treasury's funds increase, but the RRP decreases, the consumption of bank reserves will be reduced.

However, Matt King, a global market strategist at Citigroup, said that the tendency of money funds to deposit cash in RRP is likely to continue, which may mean that when the Treasury's cash increases significantly, bank reserves will be lost in large amounts.

This will happen when the world's major central banks have already absorbed liquidity through aggressive tightening actions and efforts to shrink their balance sheets. King said:

"We are shifting from the strong tailwind of global central bank liquidity over the past six months to a potential strong headwind, and what we really care about is bank reserves, which should be declining. So at this point, I strongly prefer to take a defensive position."

Priya Misra, head of global interest rate strategy at TD Securities, is worried that bank reserves will become scarce, disrupting the financing market, which is at the core of many transactions on Wall Street.

"This scarcity has serious consequences because it will push up repo rates," Misra said."High repurchase rates usually lead to a significant amount of hedging. If I were a hedge fund, my entire business model would be based on borrowing money. High repurchase rates not only imply rising interest rates but may also mean that borrowing money becomes difficult."

This impact on the financing market occurred after the debt ceiling event in 2017-2018, when the Treasury Department issued $500 billion in bills over about six weeks.

Of course, the U.S. Treasury Department is aware that a large amount of bonds could disrupt the market and inquired about this issue with primary dealers during the final refinancing period. These companies encouraged the Treasury Department to monitor potential market pressures to ensure that its replenishment of cash balances does not happen too quickly.

Jerome Schneider, head of short-term portfolio management and financing at PIMCO, said:

"The Treasury Department must rebuild their contingency fund, which will remove liquidity from the system."

In the view of Barclays strategist Joseph Abate, this could even affect the Federal Reserve's policy. If money market funds do not withdraw cash from the RRP to purchase some newly issued bills, it will "proportionally consume more bank reserves" and force the Federal Reserve to reconsider its quantitative tightening plan, which has been in place for about a year.