GavekalResearch The Daily

May 30, 2023

Page 1

Will Denyer
wdenyer@gavekal.com
Relief that there is no near-term risk the
US Treasury will not default on its debt...
...will be positive for the US dollar and—
especially—for one-month T-bills
The After-Effects Of
The Debt Ceiling Deal
Assuming it passes Congress without a hitch, Saturday’s 11th-hour deal to
suspend the US federal debt limit until 2025 will bring down the curtain on
the political drama over the debt ceiling until after the 2024 election. But for
investors, the story is far from over. The ripple-effects of the debt ceiling deal
on financial markets and monetary policy are only just getting started.
These will affect markets in three phases.
Phase one: Relief. Financial markets will heave a heartfelt sigh of relief now
the near-term possibility has been eliminated that the US government might
miss payments or potentially default on its debt, which remains the world’s
most important “risk free” asset. “Risk free,” of course, is a misnomer, as the
brinksmanship over the debt ceiling reminds us. But following the deal, US
treasuries will once again be considered as low risk as ever, at least in terms
of default risk (inflation risk is another matter).
The market will also be relieved that the Treasury did not resort to dangerous
expedients such as issuing US$1trn platinum coins and depositing them
at the Federal Reserve. Superficially intriguing, this would have handed
the Treasury a blank check, made modern monetary theory a reality, and
destroyed the Fed’s independence on monetary policy (see Debt Ceiling
Games). Instead, political compromise has imposed at least a marginal
restraint on government spending growth. The US fiscal outlook cannot be
described as healthy, but Saturday’s debt ceiling deal has made it marginally
better, not worse.
All else equal, this relief should be positive for the US dollar and for US
treasuries, especially at the short end of the curve. Last Friday, one-month
T-bill yields traded as high as 6.02% on default fears. They should now
normalize, converging with the Fed’s policy rate of 5-5.25%.

Checking The Boxes

Our short take on the latest news
Fact
UK BRC shop price index rose
9.0% YoY in May, versus 8.8%
in Apr
Japan’s jobless rate fell to
2.6% in Apr, from 2.8% in Mar
Hong Kong exports fell -13%
YoY in Apr, versus -1.5% in Mar
Vietnam’s CPI rose 2.4% YoY in
May, from 2.8% in Apr
Consensus belief
Record high on series dating
back to 2005; food prices rose
15.4% YoY, versus 15.7%
Below 2.7% expected
Weaker than -9.3% expected;
imports fell -11.9% YoY, versus
-0.6%
Inflation lower than 2.6% ex-
pected; core CPI rose 4.5% YoY,
versus 4.6%
Our reaction
Food inflation slowing on
cheaper energy; but high overall
inflation means more rate hikes
Tightening labor market will
support wage gains; BoJ’s 2%
inflation target looks sustainable
Weak external demand will
weigh on HK’s trade-dependent
economy
Easing inflation with slowing
growth to keep SBV on easing
path

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 GavekalResearch
Wiith the ceiling suspended, the Treasury
will issue debt to replenish its cash
In 2019, cash-raising by the Treasury led to
a mini-crisis in the repo market
The Daily
May 30, 2023
Page 2
Phase 2: Treasury issuance drains liquidity. With the debt ceiling looming,
the Treasury ran down its cash balances to just US$39bn, some US$540bn
below its target of one week’s worth of its outflows (give or take US$100bn;
outflows are volatile). With the debt ceiling now suspended, the Treasury
will quickly issue debt, not just to make payments (which only move money
around), but also to replenish its cash balances (which will drain liquidity
from the private sector permanently—or at least until the next debt ceiling
crisis).
The reduction in private-sector cash could put additional upward pressure
on the US dollar and weigh on asset prices (see US Debt Ceiling Risks).
Treasuries are likely to be especially affected by the combination of stepped-
up issues and fewer dollars to buy them. This could also threaten banks.
First, a sell-off in treasuries will add to unrealized losses on bank balance
sheets, which could (i) scare off depositors, and (ii) force them to raise new
capital. Second, the Treasury’s move to raise cash could suck deposits out of
the banking system and deplete bank reserves, potentially creating liquidity
problems (see How Does This Banking Crisis End?).
Phase 3: The end of quantitative tightening. After Congress increased
the debt ceiling in August 2019, cash-raising by the Treasury drained
liquidity to such an extent that the US financial system found itself facing
a mini repo crisis the following month. Initially, the Fed responded by
providing emergency loans on demand. But realizing it had gone too far
with quantitative tightening, the Fed quickly found a permanent solution by
pivoting to quantitative easing, so increasing the stock of bank reserves on a
permanent basis.
The experience was instructive. The stated aim of the Fed’s current program
of QT is to reduce reserves to levels that are “just ample.” By implication,
it wants to avoid running reserves down to levels that are less than ample,
which would risk a repeat of the 2019 mini crisis.
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 GavekalResearch The Daily
May 30, 2023
Page 3

It is hard to say where the line between ample and sub-ample lies. But the Fed
is likely to target a level of reserves, adjusted for nominal growth, similar to
the level that prevailed in late 2018 or early 2019, just before stresses appeared.
Work by New York Fed staff suggests this means a level of reserves equal
to 8-10% of nominal GDP (see Positioning For A Changing US Liquidity
Environment).
Today, total reserves are some US$700bn above this range. If necessary, banks
can borrow more reserves from the Fed, provided they have sufficient eligible
collateral. However, reserves and collateral are unevenly distributed, so some
banks may still get into trouble (see Time Is Running Out).
If the banking system shows no signs of liquidity stresses, the Fed will not
need to start QE again. But it may still end QT. QT targets the level of non-
borrowed reserves, which is now only about US$400bn above the desired
Treasury cash-raising may reduce bank
range. If the US$540bn that the Treasury hoovers up to replenish its cash
reserves
hoard comes mostly from bank reserves (rather than from the Fed’s reverse
repo facility), reserves will fall into the desired range. Therefore, even without
signs of stress, the Fed could well signal the end of quantitative tightening in
the next few months, potentially at the Jackson Hole meeting in August.

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While the potential end of QT may be a silver lining for asset prices, it is not a
good enough reason to pile on equity risk today. Investors should remember
that it will follow a significant liquidity drain by the Treasury and that an end
to QT is not the same as restarting QE. Moreover, short rates are still high,
recession risks are elevated, and equities are expensive relative to both short-
term and long-term bonds. Investors are advised to keep risk low, favoring
treasuries of average duration.

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