Is the debt deal a headwind to liquidity?

Is the debt deal a headwind to liquidity?


Derek Hamilton

  • Managing Director, Economist – Ivy Equity Boutique
  • Read bio

The US Congress has voted to suspend the debt ceiling until January 1, 2025 . Now that a severe negative shock seems to have been avoided, are US equity markets in the clear? We believe that the amount of liquidity in the system will worsen in the coming months, creating additional headwinds for equity markets beyond our expectations of a potential recession.

On January 19, 2023, the outstanding debt of the US reached its statutory limit of roughly $31.4 trillion. At that point, the US would have needed to match spending with incoming revenue, which would have required significant cuts to spending. To avoid this, US Treasury Secretary Janet Yellen began to use several accounting maneuvers, otherwise known as “extraordinary measures.” These measures have been used many times in the past to deal with the debt ceiling. In addition, Yellen drew down the Treasury General Account (TGA), which essentially functions as the US government’s checking account. Typically, the US government issues debt to bridge the gap between revenue and spending. However, when it reaches the debt ceiling, the government can only rely on “extraordinary measures” and ultimately, spending the down the TGA. Money that is spent out of the TGA increases liquidity in the system because, unlike during normal times, there is no issuance of debt to take the money out of the system.

Now that the debt ceiling is no longer a hinderance, Yellen has said she will likely significantly increase the amount of debt outstanding, in part to rebuild the TGA. We have constructed a liquidity indicator index* using data from certain portions of the US Federal Reserve’s balance sheet. This indicator includes quantitative easing (QE) and quantitative tightening (QT), certain liquidity facilities operated by the Fed, and the TGA. The chart below shows that the S&P 500® Index has generally trended in the direction of liquidity over the last few years. The Fed will likely continue its QT, which, when coupled with a substantial increase in the TGA, could result in a large reduction in liquidity and ultimately create headwinds for equity markets.

Liquidity and the S&P 500 Index

September 28, 2020 – May 22, 2023 (weekly data) Liquidity and the S&P 500 Index

Chart is for illustrative purposes only.

Sources: Macquarie, Macrobond, US Federal Reserve, and S&P Global

*Liquidity indicator index represents total assets on the US Federal Reserve’s balance sheet less Treasury general account and reverse repurchase agreements.

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The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the US stock market.

Quantitative easing is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increased the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

Quantitative tightening (QT) refers to monetary policies that contract, or reduce, the Federal Reserve System (Fed) balance sheet.

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