Liquidity Tsunami Foiled: Why This Has Major Implications For Markets
Exactly one month ago we explained that the US economy and capital markets were about to be flooded with a $1.1 trillion liquidity wave as the Treasury drew down the amount of cash held in the Treasury General Account which would plunge to just $800 billion by March 31, down a record $929BN from $1.729 trillion at Dec 31, 2020.
In other words as of early February, the Treasury expected the decline in the TGA cash balance this quarter – which is being spent to fund last December’s fiscal stimulus – to be the main driver of funding needs (for an intro primer on this topic, please see “U.S. Treasury’s cash drawdown – and why markets care“).
This matters, because as we and repo guru Zoltan Pozsar explained (here and here), this massive flood of liquidity entering the market would trigger a multi-faceted domino effect across assets, potentially pushing funding rates (FRA-OIS, repo, etc) negative, even as the glut of “safe collateral” hit demand for longer-duration, resulting in curve steepening and higher yields in longer-dated paper. And since the market is now extremely sensitive to any yield increases – reflationary or otherwise – a paradox emerged: despite over $1 trillion in liquidity hitting the market, the impact on risk assets would be largely negative.
That said, all of this however was predicated on one thing: that the Treasury’s funding needs would remain unchanged for the quarter (and beyond), which also implied that no further stimulus would pass during the first calendar quarter, and that the Treasury’s cash balance target would remain $800BN at Mar 31, all else equal.
But that it no longer the case: as of this weekend, Joe Biden’s $1.9 trillion – technically $1.8 trillion – stimulus plan passed the Senate and it’s now just a matter of fine tuning it in the House before it is signed into law. Said otherwise, it is now just a matter of day before the Treasury’s funding needs change dramatically, and the Treasury’s borrowing forecast as of Feb 1 is no longer applicable.
This has huge consequences for the market, which first was slow to adapt to the initial liquidity tsunami scenario and is now just as slow to realize that it has now been foiled.
As Wrightson ICAP economist Lou Crandall writes this morning, as Congress gets closer to passing a $1.9 trillion of stimulus, the Treasury won’t need to raise much new money to finance the plan. This also means that the government’s cash surplus problem is about to resolve itself.
“The Treasury’s current coupon offerings are generating more than $2.7 trillion of new cash on an annualized basis, and it is still sitting on a large stockpile of surplus cash left over from last year’s preemptive borrowing spree” Crandall wrote.
But, since it now “seems clear that the Treasury no longer needs to pay down bills at a rapid pace” as it needs to start prefunding the $1.9 trillion stimulus, Wrightson estimates the Treasury will start increasing the sizes of its bill offerings “in the very near future,” possibly as soon as Thursday’s regular announcement (and sees cumulative increases totaling $10b in the 4-, 6-, 8- and 17-week maturities, $6b for the 3- and 6-month bills, and unchanged one-year bill offerings).
In effect, this means that the liquidity drain that was envisioned for this quarter by the Treasury is not only no longer happening but is about to be reversed as the Treasury reassess its funding needs and restart building up its cash buffer!
In practical terms, this means that the pace of the Treasury’s weekly bill paydown will collapse from $55BN to “negligible levels” by the first half of April. And sure enough, this is already being observed in the market, where Treasury bill yields have backed up and securities maturing through April 1 are yielding 0.02% to 0.03%. It also means that expectations for negative GC Repo yields can be cast aside and that the short-end of the curve will now widen in coming days.
And since there will no longer be a flood of liquidity that dealers will have to absorb, it also means that there will be far more capacity for regular coupon securities. In short: a flattening of the curve is imminent, as are lower 10Y yields… and by extension higher stock prices as this move will likely be viewed (incorrectly) by algos and quants as a disinflationary trade.
Mon, 03/08/2021 – 12:40