U.S. Debt Ceiling Deal Nears: What's Next for Liquidity?
Alfonso Peccatiello | May 30, 2023 06:11
Assuming no last-minute surprises, it seems like we might be getting a debt ceiling deal in the US, which means you should be prepared to get overwhelmed by financial commentators' takes about 'liquidity.'
The very unnuanced story goes like this: The government needs to rebuild its Treasury General Account (TGA) buffer at the Fed, so it issues bonds and it drains 'liquidity' from the 'system.'
And here, I can picture you guys thinking: What the heck does that mean? And is it true?
Monetary mechanics are best understood through the use of good old T-accounting.
In our stylized model, we will assume 5 players (government, Fed, commercial banks, money market funds, and households) and mimic each monetary transaction – colors will help you "follow the flow of money."
Before we go to the post-debt-ceiling TGA, rebuild, let's start with bond issuance to fund deficit spending.
BLUE: The government spends $100 (deficit spending), and it injects net worth into the private sector (household’s equity) and so households now have $100 more bank deposits. These bank deposits end up as a liability for banks, and the corresponding increase in assets is a boost of $100 in bank reserves.
GREEN: The government "has" to issue $100 in bonds to "fund" its deficit spending, and banks use some of their increased reserves to buy $100 in bonds.
There is no reduction in bank reserves when the government issues bond to 'fund' deficit spending.
But what happens instead if the government issues bonds solely to refill its Treasury General Account as in a typical post-debt-ceiling-deal period?
RED: The government issues $100 in bonds without spending anything in the real economy, and banks have to absorb the new bond issuance by depleting existing bank reserves ($ -100).
GREEN: The government refills its Treasury General Account (TGA), and that is reflected in the composition of the Fed liabilities: TGA up $100, bank reserves down $100.
Get The App
This is how a TGA rebuild drains 'liquidity' (e.g., reserves) from the financial system.
If the government issues bonds without spending real economy money and banks/private sector must absorb the new issuance without any fresh new resources, bank reserves take the brunt.
But why are bank reserves referred to as 'liquidity' in the first place?
Bank reserves are money for banks: They use reserves to transact against each other and with the Fed, and you can think of them as the lubricant of the monetary mechanics pipes – the more reserves out there, ceteris paribus, the easier for banks to engage in repo markets and provide liquidity to market participants.
Reserves are also part of banks' high-quality liquid assets (HQLA), and hence a bigger reserve balance might encourage banks to take more risks in their liquidity portfolio, for instance, by buying corporate bonds – this compresses credit spreads and enacts a more favorable environment for equity investors.
On the contrary, fewer reserves are often associated with banks taking a more defensive investment stance and providing markets with less liquidity.
So, is it as easy as saying that the TGA rebuild will for sure drain liquidity from the financial system?
We will have to wait and see.
***
This article was originally published on The Macro Compass. Come join this vibrant community of macro investors, asset allocators, and hedge funds - check out which subscription tier suits you the most using this link .
Trading in financial instruments and/or cryptocurrencies involves high risks including the risk of losing some, or all, of your investment amount, and may not be suitable for all investors. Prices of cryptocurrencies are extremely volatile and may be affected by external factors such as financial, regulatory or political events. Trading on margin increases the financial risks.
Before deciding to trade in financial instrument or cryptocurrencies you should be fully informed of the risks and costs associated with trading the financial markets, carefully consider your investment objectives, level of experience, and risk appetite, and seek professional advice where needed.
Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. The data and prices on the website are not necessarily provided by any market or exchange, but may be provided by market makers, and so prices may not be accurate and may differ from the actual price at any given market, meaning prices are indicative and not appropriate for trading purposes. Fusion Media and any provider of the data contained in this website will not accept liability for any loss or damage as a result of your trading, or your reliance on the information contained within this website.
It is prohibited to use, store, reproduce, display, modify, transmit or distribute the data contained in this website without the explicit prior written permission of Fusion Media and/or the data provider. All intellectual property rights are reserved by the providers and/or the exchange providing the data contained in this website.
Fusion Media may be compensated by the advertisers that appear on the website, based on your interaction with the advertisements or advertisers.