Different views on the US debt ceiling

The US President Biden signed debt ceiling deal into law, averting historic default

>> Any impact from the debt ceiling deal?

We spoke recently about how the spending limit s contained in the bill could restrict the government’s room for manoeuvre if the economy folds, placing a greater burden on the Fed. There is another issue as well, which is the tide of treasury issuance that will be coming through in the near future as the Treasury re-stocks its coffers.

This latter issue certainly seems to have garnered most market attention. Talk of a trillion dollars of debt issuance, particularly in terms of T-bills, has created all sorts of speculation that asset prices will slide as the cash that might normally be used for other assets will be needed to buy up all the paper that the Treasury wants to issue. It does seem as if there might be some divergent views on this, just as there are divergent views about when the Fed might start to provide some relief to the front end of the curve with rate cuts.

For instance, if we look at the positioning of players in the treasury futures market we see substantial differences between the very high level of long-treasury futures positions of commercial traders, and the equally extreme short positions of non-commercial traders. Just whether this reflects bullish views by asset managers and bearish calls by the likes of hedge funds is unclear.

Asset managers may be using the market to hedge long-cash positions while hedge funds might be actively engaged in basis trades that are giving rise to large short positions but not necessarily reflecting a bearish view of the treasury market. One thing we would note about this divergence, though, is that it was at similar levels the last time the Fed got close to the end of a tightening cycle and when subsequent months saw treasury yields fall materially. Coming back to today, we would not be surprised to see the same things play out as we do look for 10-year yields to be down to the 3% region by the end of the year.

More divergence of views seems to be evident when it comes to the likely destination of this tsunami of US debt issuance. Some argue that money market funds will help the Treasury out of a hole, while there is another school of thought that foreign accounts could step up to the plate. Quite clearly the likely destination of much of this treasury paper could have a significant bearing on whether the deluge lowers treasury prices and possibly lowers the prices of other assets as well.

For if large swathes of the issuance is taken up by overseas accounts, the market will be hopeful that there will be less of an adverse spillover to other assets than if domestic accounts – particularly market makers – are left with the paper. US short-term rates are undoubtedly high but are T-bills and T-notes particularly attractive for foreign accounts?

Mr. Steve Barrow, Head of Standard Bank G10 Strategy said it would seem not. For a start, high policy rates in the US and hence high hedging costs lower the currency-hedged return for many (particularly Japan which has the highest holdings of treasuries). And secondly, this already seems to be reflected in the data as foreign buying of treasuries has been very lacklustre for some time. Quite clearly, foreign investors can buy treasuries on an unhedged basis and, if they do so, it could possibly give the dollar a lift. However, we would not hold out too much hope on this one. In fact, we tend to feel in general that this issue of a post-debt-ceiling treasury deluge will pass over the market without as much disturbance as many fear.

For a start, it is not as if the market should be surprised by the upcoming treasury supply. It was clear that the market never believed that the US would default and a corollary of this is that it must have expected (and hence positioned for) a post-debt-ceiling agreement to generate a swathe of treasury issuance right around now. In short, Mr. Steve Barrow’s call is for treasury yields to fall over time and he does not think that this prospect is undermined at all by the upcoming surge in debt issuance.