Tentative US debt ceiling deal is reached. Here's how it can play out in the coming days

While the deal's passage may bring an end to the uncertainty over a default, it may just turn out be a short-lived cheer for the financial market. Following the passage of the deal, which should be done by June 5, the US Treasury will be expected to quickly refill its empty casket with bond issuances, in turn sucking out hundreds of billions of dollars of cash from the market.

Also Read: Yellen’s debt limit warnings went unheeded, leaving her to face fallout

JPMorgan estimates that following the increase in the debt ceiling, there will be a significant issuance of approximately $1.1 trillion in new Treasury bills (T-bills) within the next seven months. The volume of these issuances is relatively substantial, especially considering the short time frame.

The anticipated bond issuance, likely at the prevailing high interest rates, is expected to result in the depletion of banks' reserves. This is because private companies and other entities will shift deposits to government debt, which is higher-yielding and relatively more secure.

Consequently, this trend will further exacerbate the existing outflows of deposits, adding pressure on banks' liquidity by reducing their available cash. As a result, interest rates on short-term loans and bonds could rise, making funding more costly for companies that are already grappling with a high-interest-rate environment.

According to a BNP strategist quoted by Reuters news agency, an estimated $750 billion to $800 billion could move out of cash-like instruments such as bank deposits and overnight funding trades with the Federal Reserve.

These funds would then be used to purchase $800 billion to $850 billion worth of T-bills by the end of September.

The consequence of this significant reduction in liquidity is a likely market correction. However, it's important to note that the reduction in deposits to buy Treasuries is not the only possible scenario.

Also Read: Biden, McCarthy forge debt-limit deal in a bid to avert US default

Another potential way out could be that money market mutual funds absorb a portion of the T-bill issuance by shifting investments away from the overnight reverse repo facility, where they lend cash overnight to the Federal Reserve in exchange for Treasuries. In such a case, the impact on financial markets is likely to be muted.

If the liquidity needs are, however, fulfilled by taking money out of bank reserves, its impact on financial markets will be much more severe, especially at a time when concerns persist about the health of the US banking system.

Despite the tentative agreement on raising the debt ceiling, there are significant hurdles in the way of securing its passage through Congress and  the problem is that time is running out.

At the beginning of May, treasury secretary Janet Yellen sent a letter to Congressional leaders, cautioning them about the potential X-date, which could occur as early as June 1. The X-date refers to the point at which the Treasury's "extraordinary measures" are depleted, posing a risk to meeting the nation's payment obligations promptly.

What if the crisis surpasses the X-date but debt payments are made?

If the deal closure surpasses the X-date, it is possible that debt service payments, including both interest and maturing principal, would still be honoured by the Treasury. To manage the situation, the Treasury might opt to roll over the maturing principal by conducting new auctions.

Also Read: Biden sounds hopeful on debt ceiling, Treasury warns of June 5 default

Priority may also be given to fulfilling interest payments over other domestic obligations such as payments to social security beneficiaries, medicare providers, agencies, and contractors.

"We estimate this could imply delaying about $25 billion per day, with
payments to be made when funds are available to do so. We assume such a scenario would prompt immediate political fallout that prompts a resolution after one week," UBS Securities said in a report.

In this scenario, the brokerage firm forecasts a little weaker economic outlook, with the impact dependent on the degree and duration of financial market disruption.

The firm also expects the S&P 500 to slip towards 3,600 points, which will result in more accumulated job and output losses but won't fundamentally alter the trajectory of financial markets, provided the payment delays are short-lived, UBS said.

A second scenario is that interest payments are missed which see the US facing more serious downgrade risk, CDS (Credit default swaps) default triggers, and downgrades to the GSEs (Government-Sponsored Enterprises).

Also Read: US Debt Ceiling: All you need to know about it

According to the UBS report, there are two key aspects that need to be considered.

Firstly, the global financial system heavily relies on the US dollar as the primary reserve currency and treasury securities as a safe investment. These assets, however, could lose their perceived level of safety and require repricing due to the potential default risk. The report suggests that the repercussions of such repricing are uncertain and could have unpredictable effects throughout the financial system.

Secondly, the report said, the constraint to resolve the default situation is primarily political in nature. While the non-payment of obligations might occur temporarily, the expectation is that it would be swiftly addressed. In other words, the default scenario is viewed as short-lived, with the assumption that the necessary political actions would be taken to rectify it. The brokerage firm anticipates a 20 percent fall in the S&P 500 in case interest payments are missed.

A month-long deadlock

The most unlikely of all the scenarios is that it takes a month to come to a political resolution and reverse the non-payment. It will result in a near 30 percent slump in equities, along with a permanent shift in equity risk premium, and substantial widening in credit spreads, as per UBS. Adding to it, the depth of a recession is also likely to double down in severity.

"However, given the severity of the recession that would likely unfold, in  our view, the funds rate is back down to the zero lower bound at the March 2024 FOMC meeting," the report stated.

Nonetheless, UBS also believes that the Fed's rate cuts would eventually be a support to markets but economic impacts will still reduce forward earnings and valuation multiples.

(With agency inputs)