Debt ceiling deal positive but Fed borrowing may prop dollar higher

Increase in debt ceiling limit positive for short term

As the high drama over the debt ceiling is over, markets should react positively as the risk of the US government defaulting on its payments has subsided. The medium-term impact of this move will cause the US dollar and US bonds to rise once again, according to Ritesh Jain of Pine Tree Macros.

This is because the US government remains short on tax receipts. Since taxes are a function of higher markets and higher nominal GDP, and both US markets and GDP are flat this year, the US government will need to build its cash chest. “Janet Yellen is going to start restocking cash balances, from currency $50 billion to possibly $600-700 billion over the next three months,” Jain explained.

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The US government has not issued any new bonds on a net basis for the past five months after it hit its debt ceiling on January 17. On the contrary, it has spent almost $500 billion from the US treasury's cash balances outside the banking system.

“Thus, US treasury supply will accelerate sharply in short order, much larger than we have previously seen,” Jain said. “This will have to compete with lending to the Fed overnight facility which is at 5 percent as banks have the option of parking cash with the Fed on an overnight basis,” he added.

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Jain believes this will also crowd out private-sector borrowing and lead to widening spreads for high-yield bonds and emerging market bonds. “As more borrowing starts hitting the market it should lead to higher USD and higher USD bonds,” he said.

The near-term, however, remains positive across asset classes, as the market is relieved about the fact that US default risk is behind.