US debt default deal fails to help markets breathe a sigh of relief

The preliminary deal still needs to be approved by the US Congress , and if it goes into effect, the massive bond issuance could drain banks of their reserves.

On May 27, US President Joe Biden and Republican House Speaker Kevin McCarthy reached a preliminary agreement to raise the debt ceiling, avoiding the country's default early next month. However, this news has not been able to ease market concerns.

"This agreement is of course good news for the market. It could also give the US Federal Reserve (Fed) more confidence in raising interest rates again. However, we still need to see what the specific content will be," commented Amo Sahota - Director of KlarityFX.

The agreement will have to be hammered out in detail and approved by the House and Senate before the US government runs out of money. This process is considered very difficult. US Treasury Secretary Janet Yellen warned on May 26 that the agency will run out of cash by June 5.

US Treasury Secretary Janet Yellen in Niigata (Japan) on May 11. Photo: Reuters — US Treasury Secretary Janet Yellen in Niigata (Japan) on May 11. Photo: *Reuters*

In addition, once this agreement is approved, the US Treasury is expected to quickly fill the budget gap by issuing bonds, attracting hundreds of billions of dollars in cash from the market. A recent estimate by JPMorgan shows that after raising the debt ceiling, the US government could issue nearly $1,100 billion in new government bonds in the next 7 months. This is a fairly large number in a short period of time.

Issuing bonds in the current high-interest-rate environment could drain banks of their reserves, as part of bank deposits are often used to buy government bonds, which are considered safe and pay higher interest.

As the wave of deposit withdrawals in the US has not ended after recent fluctuations, this will put more pressure on banks' liquidity, thereby pushing up short-term lending rates, making businesses more costly.

"This deal certainly relieves pressure on the bond market. However, it does not solve the problem of government bond yields recently rising due to the market anticipating a large amount of treasury bonds to be issued in the coming weeks, when the Treasury needs to fill the budget," said Thierry Wizman, a strategist at Macquarie.

BNP strategists estimate that $800 billion to $850 billion could flow into U.S. government bonds by the end of September. "Our concern is that if this liquidity leaves the system, for whatever reason, markets could fall," said Alex Lennard, chief investment officer at asset manager Ruffer.

Mike Wilson, equity strategist at Morgan Stanley, agrees. "The Treasury's issuance of bonds will draw a large amount of liquidity from the market. This could be a catalyst for the market to correct," he explained.

Some bankers worry that financial markets may not fully appreciate the risk of liquidity being drained from banks’ reserves. So far, the S&P 500 has held up well. The spread between investment-grade and junk bonds is also very small.

"Risk asset markets have yet to fully reflect the impact of tightening liquidity through large-scale government bond issuance," said Scott Schulte, head of debt markets at Citigroup.

However, a liquidity crunch is unlikely. Some of the issuance could be absorbed by investment funds. In that case, “the impact on the broader financial markets would be limited,” said Daniel Krieter, head of fixed income strategy at BMO Capital Markets.

Banks are hoping the debt ceiling impasse will be resolved without causing major disruption to the asset class. "The credit markets are betting that Washington will solve this problem. So if it doesn't get resolved next week, we're going to see some volatility," said Maureen O'Connor, head of fixed income at Wells Fargo.

Ha Thu (according to Reuters)

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