Tidbits on the TGA
TLDR
Now feels as good of a time as ever to take some shots on the short side. My bearish take actually contemplates the debt ceiling getting raised smoothly (the worst of it for the markets being on the other side), however a government shutdown or prolonged political battle would add volatility beforehand as well. Additionally, we continue to see economic data rolling over, liquidity worsening, equity breadth weakness with only the S&P 5 holding indices up and monthly opex this week. My favorite candidates to express the short side are financial equities that haven’t been properly marked to market yet (ie some private equity or private credit/BDC names) and large cap tech names that are back trading at 2021 P/S and P/E levels (ie Apple). The punching bag that regional banks have become are also likely an okay candidate too.
The one chart that can’t be unseen
On top you have the Treasury General Account (TGA) balance in blue overlaid against the Fed’s balance sheet (purple). You will notice the last 3 times the TGA was meaningfully replenished (upward arrows), the Fed was either:
Expanding its balance sheet [Sept ‘19 and March ‘20]
Not expanding its balance sheet [Dec ‘21] (technically it was since the balance sheet peaked in April ‘22 but they were using forward guidance to signal the end of QE into QT)
In Sept ‘19 during the money market turmoil (can read about it here and here), US 10 year interest rates (light blue, middle) remained flat to slightly up, despite the Fed restarting QE to support the treasury market. We all know what happened in March ‘20 when the Fed much more explicitly monetized the government’s debt burden via “unlimited bond buying” and interest rates cratered.
Dec ‘21 was the last time the TGA balance was this low ahead of the most recent debt ceiling increase, meanwhile the Fed began guiding towards upcoming rate hikes and balance sheet reduction. The TGA replenishment coincided with a large upward movement in interest rates, with falling bond prices serving as the release valve without the Fed’s support. This instance was much less kind to equities (S&P 500 plotted in yellow, bottom), owing in part to decreased liquidity and higher nominal rates.
Fast forward to today and you have a similar setup to Dec ‘21. The Fed remains steadfast in its attempts to hold short-term rates higher for longer and continuing balance sheet rolloff by ~$95 billion per month. The Treasury also just announced updated borrowing estimates for Q2 and Q3 which were both significantly raised from its previous January estimates. It’s likely the Treasury will need to issue between $500 billion - $1 trillion in additional funding over the next 1-2 quarters in order to fund ongoing deficits and replenish the TGA, a direct drain on market liquidity.
This also comes at a time when US Treasury market liquidity is drying up and interest rate volatility is elevated (MOVE index below in blue).
The Fed’s options
Basic accounting would tell you that in order to combat the problem above, the government could either cut costs (spending) or increase revenues (taxes). There’s also a third option that most governments have chosen which is yield curve control and QE - artificially suppressing interest rates to be able to afford and service these ever increasing debt burdens. This works until it doesn’t - at which time it bears severe consequences which we are starting to see the early innings of today.
Reduce government spending: while the chances of this happening are low, it would be negative for the economy and deflationary if it did. The government’s fiscal deficit spending has been a main driver behind recent inflation and the economic resiliency as much of the funding flows to lower and middle income households - major entitlements comprise nearly 50% of the total budget. Given these cohorts spend nearly 100% of their household incomes, the majority of each extra dollar spent via large fiscal deficits flows back into the economy.
Increase taxes: this is also a net negative for the economy and near-term deflationary, however less so than above. This is because tax increases in the US (progressive system) typically affect the upper class much more as many of the lower income households pay no income tax. Meanwhile, the upper class tends to spend a smaller portion of their disposable incomes and therefore this would be less negative for aggregate demand.
Do neither and make it up as you go: as many previous examples would indicate this is by far the most likely path, with the ultimate outcome varying significantly based on whether or not the increased debt is monetized by the Fed. History tells us the Treasury will likely give it a go on their own, only for the Fed to be forced back into QE to stabilize markets.
The likely path
Focusing on #3 above, if markets are functioning smoothly the Fed will maintain its restrictive policy stance via balance sheet runoff and higher for longer interest rates. Despite CPI prints undoubtedly trending lower and already being surpassed by the Fed funds rate over the coming months, they have repeatedly indicated their interest in holding firm until CPI is closer to their 2% target. Therefore a preemptive pivot to balance sheet expansion and debt monetization is off the table.
This leaves the market as the sole purchaser to absorb the large incoming US debt issuance which I suspect puts upward pressure on interest rates - likely a negative for risk assets as equities have largely been driven by a repricing of duration risk. This would create a setup ripe for an asset flush, even including recent safe havens like gold if it sent real rates higher. Higher rates also elevate the temperature of the current banking crisis via worsened mark to market losses (from aforementioned repriced duration) and sustained deposit flight, likely motivating Fed intervention and a return to balance sheet expansion.
It’s difficult to envision the dollar strengthening in this environment. Obviously fiat currencies are a relative game and worse things can happen elsewhere, but ‘cleanest shirt in the dirty laundry’ is not an investment thesis I want to hang my hat on. The best bull case for the dollar I’ve heard is global recession which would simply tack on a few more trillion to the amount of new US debt issuance the Fed would be required to monetize. Generally speaking I think fiat currency relative value is an overblown topic given they’re all circling the drain relative to other assets that are priced in them.
Furthermore, USD weakness is net positive for commodity prices (and thus inflation). For commodities to appreciate significantly I think you need more than just USD weakness, but the relationship is undeniable. Higher commodity prices are generally correlated with higher interest rates which is primarily a factor of inflation expectations.
Unknown Variables
Timing: Is the X-date actually early June? What if the X-date is later and June tax receipts bridge the TGA to late summer? Or what if the X-date is early to mid-June and there’s a very brief shutdown until the receipts begin refilling the TGA and operations resume?
Resolution: The above assumes a proper resolution where the debt ceiling is raised and a full $500 billion - $1 trillion in government debt is issued. But what if a small interim solution is reached that just kicks the can to end of summer?
Positioning: There’s a large speculative short position built up in treasuries (betting for higher rates) - is this too consensus? PauloMacro makes a good point here and here.