ACTV - A Debt Ceiling Deal May Lead To Giant Stock Market Liquidity Drain

2023-05-21 06:15:00 ET

Summary

• A debt ceiling agreement is likely to come soon.
• An agreement means the Treasury will be able to refill the Treasury General Account.
• This will suck a tremendous amount of liquidity out of the markets.

The ongoing debt ceiling debate continues, and the equity markets have not paid much attention. It doesn't appear that the equity markets should be overly concerned about the debt limit. These debates tend to occur regularly, and once the political posturing is done, the limit is typically raised and life moves on.

However, the issue this time is that once the debt limit is increased, the Treasury will likely move swiftly to resume issuing Treasury securities, causing the Treasury General Account to increase.

A Higher TGA Means Lower Reserve Balances

The Treasury General Account is a liability held at the Fed, and any changes in the TGA affect reserve balances. As the TGA increases, it leads to a decrease in reserves, which can result in reduced liquidity levels in the markets.

As of May 18, the Treasury General Account had fallen to around $58 billion. Considering this, not only will the debt limit need to be raised quickly, but the Treasury will also need to begin issuing new debt promptly.

Since the conclusion of quantitative easing ((QE)), changes in the Treasury General Account have significantly impacted the size of reserve balances. By examining an inverted chart of the TGA compared to the NASDAQ 100, one can observe that fluctuations in the TGA influence the equity index. The recent decline in the TGA has been caused by a weak tax season and the debt limit issue. Due to the decrease in the TGA, equity prices have remained elevated and even experienced a slight rally over the past week.

A Falling TGA Has Added Liquidity

But one reason why the equity market hasn't extended further over this period is that the size of the Fed's balance sheet has been shrinking again, and to some degree, that has been neutralizing some of the effects of the declining TGA account.

The Fed balance sheet briefly expanded following the collapse of SVB, as banks accessed the Fed's discount window, which gave reserves a big boost, helping to lift equity prices. Additionally, the decline in the TGA helped to free up even more reserves. But now that the usages at the discount window are declining and the Fed balance sheet is shrinking, reserves have started to decline again.

If the Fed's balance sheet continues on a path of QT, the size of the balance sheet will continue to decline; as the Treasury begins to rebuild the size of its account held at the Fed, this should result in the reserve balance declining again. The only unknown is where the money for the added Treasury supply will come from.

Reverse Repo Facility

If the added supply comes from money market accounts, it could result in a decline in the reverse repo facility activity. Reverse repurchase agreements with the Fed also act as a liability on the Fed's balance sheet, and as reverse repo activity rises, it too works to decrease reserve balance.

However, if money comes from money market accounts, it could begin to shrink the size of the reverse repo facility since most of the money that goes into the reverse repo facility comes from money market accounts. If that happens, it could neutralize some of the effects of the Treasury General Account rising again. Since March, the size of money market accounts has increased as there has been a flight out of lower-yielding bank deposit account into higher-yielding money market accounts, with the ICI Money Market account totals rising to around $5.3 trillion. This has helped to push reverse repo activity higher. But as long as the reserve repo facility stays relatively stable and more banks do not start to access the Fed's lending facility, the Fed's balance sheet should continue declining, leading to lower reserve balances.

Valuations

Generally speaking, the NASDAQ 100 ( NDX ) market cap has traded between 4 to 5 times the size of the reserve balance and is currently trading at the upper end of that range at 4.95. The last few times the ratio had gotten this high was in late March 2022, August 2022, and February 2023; each of those times collimated with a substantial decline to follow.

So while there might be some short-term optimism around lifting the debt ceiling, it will likely lead to tremendous liquidity getting sucked out of markets as the TGA rises, reducing the overall size of reserve balances.

How much reserve balance ultimately falls depends on several factors, but these numbers are easy to track daily. I do this for subscribers of my Seeking Alpha Investing Group service, Reading The Markets. These numbers do help in formulating my views on the market, and knowing that the debt ceiling resolution would lead to a refill of the TGA has not only kept me leaning bearish but a non-believer in the rally thus far this year and serves as yet another reason why the bulls remain trapped.

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