With the freshly inked debt ceiling deal, the US Treasury is poised to release a deluge of new bonds in order to swiftly replenish its financial reserves.



However, this move is expected to exacerbate an already dwindling liquidity situation, as bank deposits are tapped into to cover the issuance. Alarm bells are ringing on Wall Street, as market experts warn that the financial markets are ill-prepared for the potential consequences.



The impending negative impact of this bond flood could surpass the repercussions of previous clashes over the debt limit. The Federal Reserve’s quantitative tightening initiative has already chipped away at bank reserves, while cautious fund managers have been amassing cash reserves in anticipation of an economic downturn.



Nikolaos Panigirtzoglou, a strategist at JPMorgan Chase & Co., forecasts that the surge in Treasury bond supply will compound the effects of quantitative tightening, resulting in a nearly 5% decline in the overall performance of stocks and bonds this year.



Macro strategists at Citigroup Inc. present a similar analysis, indicating that a median drop of 5.4% in the S&P 500 over a span of two months could follow such a substantial liquidity drain, along with a 37 basis-point spike in high-yield credit spreads.



Commencing on Monday, these bond sales will reverberate throughout every asset class, further depleting an already shrinking pool of available funds. JPMorgan estimates that overall liquidity, as measured by a broad indicator, will decrease by a staggering $1.1 trillion, down from approximately $25 trillion at the beginning of 2023.



“This is a very big liquidity drain,” says Panigirtzoglou.



“We have rarely seen something like that. It’s only in severe crashes like the Lehman crisis where you see something like that contraction.”



JPMorgan estimates that the combination of this trend and the Federal Reserve’s tightening policies will cause the measure of liquidity to decline at an annual rate of 6%. This stands in stark contrast to the annualized growth experienced for the majority of the past decade.







After months of contentious debates in Washington, the United States has managed to avert default by resorting to extraordinary measures to finance its operations. However, with the immediate crisis behind them, the Treasury is now preparing to embark on a borrowing spree that could exceed $1 trillion by the end of the third quarter, according to estimates from Wall Street. This borrowing frenzy will kick off with a series of Treasury-bill auctions on Monday, totaling over $170 billion.



The impact of this massive influx of funds into the financial system is difficult to predict. Short-term Treasury bills have a range of potential buyers, including banks, money-market funds, and a diverse group of entities collectively referred to as “non-banks.” This category encompasses households, pension funds, and corporate treasuries.



Presently, banks have limited interest in acquiring Treasury bills due to the relatively low yields they offer compared to what banks can earn on their own reserves. However, even if banks opt to stay on the sidelines during the Treasury auctions, a significant shift by their clients from deposits to Treasuries could have far-reaching consequences. Citigroup has conducted modeling exercises based on historical instances where bank reserves declined by $500 billion within a 12-week period to approximate the potential outcomes that may unfold in the coming months.



“Any decline in bank reserves is typically a headwind,” says Dirk Willer, Citigroup Global Markets Inc.’s head of global macro strategy.



In the most optimistic scenario, the surge in Treasury supply would be swiftly absorbed by money-market mutual funds. It is assumed that these funds would use their own available cash reserves to make purchases, thereby leaving bank reserves unaffected. However, recent trends indicate that these funds, historically significant buyers of Treasuries, have shifted their focus towards the Federal Reserve’s reverse repurchase agreement facility, enticed by the prospect of better yields.



This brings us to the remaining players: the non-banks. They are expected to participate in the weekly Treasury auctions, but their involvement comes at a cost to banks. These buyers will likely tap into their bank deposits to free up cash for their Treasury purchases, exacerbating the ongoing capital flight that has already resulted in the closure of regional lenders and destabilized the financial system throughout this year.



The government’s increasing reliance on what are known as “indirect bidders” has been apparent for some time, as highlighted by Althea Spinozzi, a fixed-income strategist at Saxo Bank A/S. This trend underscores the shifting dynamics within the Treasury market and the potential consequences it may have on the broader financial landscape.



“In the past few weeks we have seen a record level of indirect bidders during US Treasury auctions,” she says.



“It’s likely that they’ll absorb a big part of the upcoming issuances as well.”







Despite the temporary relief of the United States averting default, the potential repercussions of a looming liquidity crisis have momentarily faded from the spotlight. In the midst of this, investor enthusiasm surrounding the possibilities of artificial intelligence has propelled the S&P 500 to the precipice of a bullish market, following three consecutive weeks of gains. Interestingly, liquidity conditions for individual stocks have shown signs of improvement, defying the prevailing market trend.



However, concerns persist regarding the customary consequences that accompany a significant decline in bank reserves. During such periods, stock markets typically experience a downturn, and credit spreads widen, with riskier assets bearing the brunt of the losses. These apprehensions underline the ongoing unease among market participants, as they grapple with the potential implications of a liquidity squeeze.



“It’s not a good time to hold the S&P 500,” says Citigroup’s Willer.



Barclays Plc reports that despite the rally fueled by artificial intelligence, the overall positioning in equities remains largely neutral. Mutual funds and retail investors have opted to maintain their current positions rather than making significant changes. This suggests a cautious approach among market participants, possibly reflecting a sense of uncertainty or a desire to wait for further developments before taking more decisive actions in the equity market.



“We think there will be a grinding lower in stocks,” and no volatility explosion “because of the liquidity drain,” says Ulrich Urbahn, Berenberg’s head of multi-asset strategy.



“We have bad market internals, negative leading indicators and a drop in liquidity, which is all not supportive for stock markets.”