What’s next after tentative debt limit agreement?

Following about a month of negotiations after the approval of a debt limit bill by the Republican majority in the House of Representatives on April 26th, President Joe Biden and House Speaker Kevin McCarthy revealed on Saturday evening their achievement of a preliminary compromise agreement.

Under the terms of the agreement, the debt limit would be suspended for approximately two years, extending beyond the 2024 election. Additionally, the agreement entails placing a cap on discretionary spending for 2024 at a similar level to 2023, while imposing a growth limit of 1% on discretionary spending in 2025. The proposed legislation also includes provisions to reclaim certain unutilized Covid relief funds, reduce funding for the Internal Revenue Service (IRS) by approximately USD10 billion, strengthen work requirements for the food stamp program, streamline the energy permitting process, and urge Congress to allocate funding for the government through 12 separate appropriations bills rather than a single omnibus bill.

The complete text of the legislation was made available on Sunday night, allowing lawmakers a 72-hour period to review it before a vote can take place. If everything goes as planned, a vote in the House of Representatives could occur as early as Wednesday/Thursday, followed shortly by the Senate. Although certain lawmakers expressed their opposition upon the announcement, it is anticipated that there will be sufficient support to pass the bill in both chambers of Congress before the Treasury Secretary Janet Yellen's announced X-date of June 5th.

Since the compromise agreement managed to circumvent the more substantial spending reductions proposed by the Republicans, I do not anticipate it to significantly alter the economic outlook. Consequently, I have chosen to maintain my macro forecasts without any revisions.

Looking at the rates market, resolving the debt limit issue will have a significant impact. It will enable the Treasury to issue a considerable number of bills, aiming to replenish the Treasury General Account (TGA) balance to a more favourable level. The Treasury has projected a TGA balance of USD550 billion by the conclusion of June and USD600 billion by the end of September, under the assumption that a debt limit increase or suspension is enacted.

I’m of the opinion that the Treasury can promptly increase the issuance of bills, particularly focusing on short-term maturity bills. This can be attributed to the substantial demand for highly liquid assets, as evident from the historically high levels of money market fund assets and the elevated volume of the Federal Reserve's reverse repo program (RRP), currently standing at USD 2.2 trillion.

A swift rise in the Treasury General Account (TGA) balance is likely to come at the expense of the Fed's RRP volume. The substantial issuance of bills may result in their lower cost compared to other short-term instruments, potentially making bills more appealing than the Fed's RRP program. Consequently, rates in the short-term market will adjust accordingly. These expectations have caused front-end swap spreads, such as 2-year spreads, to decrease in value.

A resolution to the debt limit issue should create a favourable risk-on environment. I have already witnessed a preview of this in recent weeks when optimism surrounding a potential agreement in Washington led to increases in stock prices and bond yields, and vice versa.

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