Investment Strategy Brief:
Debt Ceiling Deal = Liquidity Drain?

Below is a transcript of this week’s video.

Hi, this is Mike Reynolds with Investment Strategy at Glenmede

President Biden signed the Fiscal Responsibility Act over the weekend, which has finally put an end to the latest installment of debt ceiling drama. This suspends the debt ceiling until 2025 and allows the Treasury to once again return to the debt markets to issue new bonds and finance ongoing government spending. It was a bit of a close call, as the cash balance in the Treasury’s General Account was running dangerously low, consistent with prior episodes of debt ceiling brinksmanship over the past few years.

One thing investors should be aware of here is, as the Treasury rebuilds that cash account, this acts as a drain on liquidity in the financial system. That extra demand for dollars from all the issuance of new Treasury bonds and bills is one less dollar’s worth of demand for other financial assets. Now, the cash balance was abnormally large in 2020 because the government needed more cash on hand to pay out stimulus checks, enhanced unemployment benefits and PPP loans. It’s unlikely the Treasury will need to raise that much cash over the coming weeks, but it will still need to get its balance back in line with more normal target levels.

This has an impact on returns for other assets like equities. Even over just the last few years, the liquidity environment created by the Treasury’s activities around debt ceiling dates has had a noticeable impact on the S&P 500. When the Treasury spends down its cash balance, dollars are plentiful throughout the system, which was a tailwind for equities in both the 2021 and 2023 debt ceiling spend downs. But over the period in between these debt ceiling dates, the market has actually been lower on average on the other side.

Not only are we expecting tighter liquidity from the fiscal side, but monetary policy continues to drain liquidity from the system as well. The Fed is well along in its process of normalizing the size of its balance sheet after a few years of large bond purchases around the pandemic. Assets on the Fed’s balance sheet currently add up to around 33% of U.S. GDP, ticking higher around the regional bank issues surrounding Silicon Valley, Signature and First Republic Banks. The level that is likely consistent with the Fed’s policy of ample reserves is probably closer to 20%, so the general trend is still lower here.

These are popping up in an environment when government policy appears to be tightening the belt on several fronts. The Fed has already raised rates significantly over the past year, and there are expectations they may have another rate hike or two in the pipeline for the next few months. On the fiscal side, the debt ceiling deal came with a dose of medicine in the form of spending cuts in an attempt to fight off rising interest costs for the federal government. All else equal, this is all contributing to a period of heightened risk of recession, coupled with liquidity headwinds that could lead to equity market volatility in the near-term.

So to summarize, now that the debt ceiling has been suspended until 2025, the Treasury is going to need to build back its cash balance over the next few weeks, which has historically been associated with deteriorating liquidity conditions and equity market volatility. In the meantime, the Fed continues to wind down the size of its balance sheet, which also has a net of effect of draining liquidity from markets. These are occurring against a backdrop of tightening monetary and fiscal policy and a still-heightened risk of recession. Altogether, investors should be on watch for any associated volatility in markets in the near-term as markets adjust to this changing liquidity regime.

Thanks for listening! And please don’t hesitate to reach out with any questions.

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