The debt ceiling will return to haunt us on March 16. Here’s what I’m looking at in preparation. First, a little background.
When the US Treasury issues net new supply it takes cash out of the market because dealers and investors need to raise cash to buy the new securities. When the Treasury pays down debt, as it does every year in April, it puts cash back into the accounts of the erstwhile holders of the maturing paper.
That tends to boost the market. When that cash is returned to the erstwhile holders of the paper, they look for a place to redeploy the cash. They will typically bid more aggressively to purchase whatever paper is available. That tends to push money market rates down. It may also spill into bond yields, and even contribute to a rally in stock prices.
The biggest paydowns always occur from mid April to mid May as the government processes April 15 tax receipts.
File that away in your memory bank for a moment, as I turn to another key to understanding the impact of Treasury supply on the markets.
The TBAC (Treasury Borrowing Advisory Committee) is a committee of Primary Dealers tasked by the Fed to provide it with a quarterly forecast of how much Treasury debt will be needed to cover the deficit for the current and next quarters. It reports to the Treasury quarterly at mid quarter. The 1st quarter mid quarter report was issued last week along with the advance report for the second quarter. The advance report for the current quarter was issued in November.
The TBAC just issued its mid quarter forecast for the first quarter of 2017. There was a big change from the November advance estimate. The TBAC is now recommending a big paydown of T-bills in February. That’s a direct return of cash to the bill holders, such as dealers and other banks. The TBAC wants the Treasury to offset that squandering of cash by issuing a cash management bill (CMB) of $45 billion in March. A CMB issuance in March is not unusual. The government usually needs cash to tide itself over until the big April 15 tax windfall.
The Federal Government’s cash disbursements are heavy in February and March as the IRS sends out tax refunds. With tax collections low in February and March the Treasury usually issues CMBs to cover those expenses. The extra bill supply pulls cash out of the markets and into the US Treasury, and often results in some market weakness in the February-March period.
At the same time, the economic data for March may get a bit of a boost. The Treasury puts the cash back into the economic stream as it issues the tax refunds to the public and business taxpayers. The lucky taxpayers then head off to Walmart to spend their windfalls.
The Treasury gets a small windfall in mid March from corporate tax collections. It gets its biggest tax windfall on April 15 of course. This comes from individual tax collections and estimated corporate taxes for Q1.
Initially the Treasury uses that cash to pay down billions in outstanding debt. It’s only temporary, usually covering a 3-4 week period from mid April to mid May. But it’s serious money and it flows directly into the accounts of dealers and investors who had held the paper that was paid off. They look to park the cash somewhere. It’s often in bonds, but sometimes there’s a spillover effect into stocks. That continues until mid May when the Treasury starts heavy borrowing again.
At the end of 2016 the Treasury had been sitting on record cash of nearly $400 billion. They had built that cash pile as a rainy day fund to help defer the debt ceiling day of reckoning. It is set to be reimposed in March. In past reports I speculated about what Trump would do with the cash. Evidently he wants to spend the money now and worry about the debt ceiling sooner rather than later. He figures he can intimidate Congress into bending over.
Obama left Trump with this big cash pile, expecting that he was leaving it for Hillary. It was like giving a pile of matches and 400 drums of gasoline to a pyromaniac. Obama’s miscalculation won’t end well.
The TBAC’s new estimate for February calls for $79 billion in paydowns of Treasury bills and just $44 billion in net new issuance of notes and bonds. The result will be a paydown of $33 billion. That would be an unusual bullish influence for February. The government has always needed to raise cash in February, so it is usually a big net borrower. Sending cash back to investors instead would be quite a turnabout.
March is now expected to see heavy new supply including $91 billion in net new bill supply and $57 billion in new notes and bonds. The total supply hit of $148 billion would normally be enough to crush the market. If foreign central banks and others pull in their horns even more than they already have, it could turn into a bloodbath for both stocks and bonds.
There will be no respite in early April. The Treasury will borrow another $26 billion in new bills at the beginning of the month.
Then the tax windfall comes in on April 17 this year, thanks to the 15th falling on a weekend. The TBAC forecasts paydowns of $123 billion for the rest of April and another $10 billion in early May. After that another big slug of supply will come in June.
If you ever wondered why sell in May and go away works so often, that’s the reason. The pattern is the same every year. A big influx of cash into the market and there’s less supply to absorb, in April and early May. That tends to boost prices when all else is equal. The Treasury then resumes the supply pounding as May draws to a close. Summer and fall see the weakest tax collections and the heaviest Treasury borrowing. When the financial markets must absorb that much supply, it usually puts downward pressure not just on bond prices, but stocks as well.
The wild card this year will be the debt ceiling. If there’s no deal before the Treasury needs to suspend borrowing, then that would be bullish. We have seen this drama before in September-October 2015 when we went through that contrived debt ceiling crisis. The government was forced to stop borrowing. The withdrawal of Treasury supply from the market forced investors to plow the ensuing cash buildup into existing paper in the secondary market. That included not just Treasuries, but also stocks.
As long as the Treasury is not in the market borrowing, no matter how much chaos is going in the political sphere, there will be excess cash in investor accounts. We’ve seen it before. To everyone’s surprise but ours, stock and bond prices rose.
If by some miracle a deal is done and there’s no suspension of borrowing, I would expect Treasury borrowing to rise as the US economy’s weakening trend persists. At the same time the secular trend of slowing demand for Treasuries will continue. The good news of a debt ceiling deal would be bad news for the markets.
This report is derived from Lee Adler’s Wall Street Examiner Pro Trader Monthly Treasury Supply and Demand Report. You can read the rest of the story there. Subscribe today for a 90 day risk free trial.
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