In the past month we have witnessed a change of tone from the world’s most important central bank, the US Federal Reserve, on its current monetary policy guidance, from an accommodative stance (that has been more or less the same in this past decade) to a slightly more hawkish tone.
This is likely to bring forward its interest-rate hike cycle to start in 2023 from 2024 to combat heightened inflationary pressures. Tapering on its current quantitative easing programme is also likely to come earlier, with some market watchers pencilling in Q4 2021.
Risk assets, especially US stocks, are now trading at overstretched valuation levels in general. The S&P 500’s Shiller price to earnings ratio (cyclical adjusted for inflation) is at 38.13 as at 6 July, its highest level since the December 1999 level of 44.19 before the dot.com bubble burst in early 2000. The primary driver that supports higher stock prices in the US and worldwide has been the enormous amount of liquidity injected into the financial markets in the last 12 years, via the Fed and the other central banks since the aftermath of the financial crisis in late 2008.
So, a small percentage of liquidity withdrawal in the markets is likely to trigger a larger negative feedback loop into risk assets such as stocks, triggering a potentially horrendous correction given that market participants have been accustomed to an almost zero interest-rate environment over the past 12 years, accompanied by abundance of liquidity that has been swooshing around in the system.
Interestingly, after the last Fed’s FOMC meeting on 16 June, market participants have taken the hawkish guidance like a pinch of salt, and bided US stocks after it declined by an average of -2% after the meeting, before the S&P 500 skyrocketed to print fresh all-high closing highs for seven consecutive sessions last week, its best streak since 1997, led by US big tech stocks. It seems like business as usual 'buy the dips' behaviour has emerged as the winner (again).
Right now, there is another key event that is lurking round the corner, namely the US Treasury’s debt ceiling limit will come into effect on 1 August.
What is the debt ceiling?
The debt ceiling is the maximum amount the US government can borrow as dictated by the Congress to meet its financial obligations. When the ceiling is reached, the Treasury cannot issue any more debt instruments across all maturities such as bills, notes or bonds and it can pay its obligations via tax revenues. The debt ceiling has been suspended for two years since July 2019 and if Congress runs into a roadblock and are not able to increase it or suspend it again, US government borrowing could get tricky, with the consequences of technical default. In the past, politicians have used threats of not raising the debt ceiling to gain political mileage or concessions on other matters.
What are the after-effects?
Firstly in 2011, a split House And Senate took the debt-limit debate down to “last hour” that led to a sovereign credit rating downgrade on US sovereign debt for the first time by S&P Global Ratings and later in 2013, Fitch Ratings put the US rating on negative watch after a protracted debate on the debt limit among politicians. During 2011 US debt ceiling crisis, the deadline was 2 August 2011 and thereafter the US government would exhaust its borrowing authority. Political squabbles started in early July 2011 and stretched towards 2 August 2011, before it was resolved in the last hour by the signed-off debt ceiling bill by then President Obama. The S&P 500 declined by -7% from 8 July 2011 to 2 August 2011.
During the 2013 debt ceiling crisis, the political infighting started in September 2013, leadingto a partial US government shutdown on 1 October 2013 that lasted for 16 days. The debt ceiling crisis was resolved on 16 October via the Senate’s passage of the Continuing Appropriations Act, 2014. During this tremulous political period, the S&P 500 declined by close to -5% from 18 September 2013 to 9 October 2013.
What can the US Treasury do ahead of 31 July?
The Treasury can reduce its cash balance in its general account as it is noy allowed to run up its cash balances ahead of the debt ceiling, a regulatory constraint placed to prevent circumventing the borrowing limit. As of 1 July, the Treasury’s cash balance was US$784 billion and it has set a reduction target of US$450 billion by end of 31 July, end of the current debt limit suspension period.
Upcoming huge inflow of cash from US Treasury
The process of running down on its cash balance is likely see a significant amount of liquidity added into the financial markets. These additional cash will end up on commercial banks balance sheets and may cause the cash reserves that banks hold at the Fed to soar to around US$5 trillion from about $US3.4 trillion at the start of the year. The surge in cash reserves will increase bank’s assets and may cause them to hit regulatory leverage requirements which limit the ratio of their respective total assets to equity capital. In addition, last year’s relaxation of supplementary leverage ratio that excluded Treasuries and deposits with Federal Reserve banks from the calculation of the leverage ratio has expired on 31 March and not extended by the Fed.
Thus, banks need to set up aside higher levels of capital to meet reserve requirements due to the upcoming significant cash inflow via the winding down of the US Treasury’s cash balance. In turn, it may cause banks to have less capital resources to lend against collaterals and securities in the short-term funding markets such as the repo and money markets that increases the risk of triggering a spike in short-term interest rates.
These short-term funding markets are a critical source of financing for hedge funds and investment banks for more speculative oriented activities. Hence, a potential spike in short-term interest rates may cause a disorderly unwinding of such activities which in turn can trigger a negative feedback loop into risk assets such as equities at least in the short-term horizon.
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