Debt Ceiling Leads To Liquidity Drain

Debt Ceiling Crisis Morphs

08 Jun

The US Debt Ceiling and Its Impact on Liquidity and the Financial Market

The debt ceiling debate in the United States has significant implications for the country's economy and financial markets. The recent agreement to suspend the debt ceiling until January 2025 has led to an expected surge in treasury bills issuance. The Treasury Secretary has expressed intentions to fill up the Treasury General Account (TGA) and issue a trillion dollars worth of T-bills into the market once the debt ceiling is raised. T-bills are short-term government securities that mature in one year or less.

Impact on Liquidity and Financial Markets

The TGA refilling process is a liquidity drain, as it pulls liquidity out of the economy and markets instead of providing it. This happens because investors prefer to give their money to the Treasury and make a 5.25% return rather than take risks. This also occurs as banks' balance sheets would contract as they use their bank reserves to purchase the T-bills

Liquidity refers to the ease with which an asset can be converted into cash without affecting its market price. A liquidity crisis occurs when there is a shortage of cash or cash equivalents in the market, making it difficult for businesses and individuals to access funds. With limited liquidity banks are at higher risk of going bust & stocks could collapse due to selling to raise liquidity. Additionally, rates could explode higher, as there would be an influx of supply hitting the market in a very short period.

The replenishment of the Treasury General Account (TGA) is comparable to an extra 25 basis point increase, which is disadvantageous for smaller banks that rely more heavily on reserves. Furthermore, the funding of the TGA account coincides with market downturns following the COVID-19 pandemic and a market crash in December 2021. During this time, the NASDAQ and Bitcoin experienced significant highs in November 2021 when the TGA account hit its lowest point.

The Federal Reserve's Balance Sheet and Bank Reserves

To analyze the impact of raising the debt ceiling on liquidity, we must closely examine the Federal Reserve's balance sheet. Banks have accounts with the Fed, with an aggregate total of about $3.2 trillion in bank reserves. Bank reserves are funds that banks hold in their accounts at the Federal Reserve to meet reserve requirements and to clear financial transactions.

Banks also have another account that is a liability of the Federal Reserve called Reverse Repurchase Agreements (RRP) or reverse repo, which has an aggregate total of $2.2 trillion. Reverse repos are short-term transactions in which the Federal Reserve sells securities to banks with an agreement to repurchase them at a later date. This helps the Fed manage short-term interest rates and provides banks with a temporary source of funds.

Before the economic downturn in 2019, the percentage of reserves that banks had relative to deposits was about 12%, whereas it is now at 17%, indicating a significant buffer. This suggests that while there may be some challenges with liquidity, the situation is not as dire as some may suggest.

Non-Bank Entities and Treasury Bills

The impact of banks redirecting their reserves to the Treasury General Account (TGA) is twofold: it significantly reduces bank reserves, leading to a decrease in deposits. Conversely, non-bank entities investing in T-bills could yield higher returns compared to money market funds or reverse repo, potentially reducing bank reserves but not to the extent of a severe liquidity crisis.

The potential liquidity crisis can affect mid-size and small-size banks differently from mega-banks. Smaller banks, with limited access to resources, may face greater vulnerability to market fluctuations, thus treading cautiously. As the significance of liquidity grows, it is crucial to recognize the rising importance of counterparty risk in banks' decision-making. When liquidity becomes a concern, understanding and assessing counterparty risks become vital to safeguard contractual parties from potential defaults.

 

For more analysis on these topics, check out these articles:

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