What brings an end to a bull market, I am often asked, since I am known to be bearish at this time. Usually, it’s just exhaustion. But money flows are always involved in one way or another. So here is a scenario almost no one is thinking about.
On March 15th of this year, the U.S. Federal Government went back under a debt ceiling which had been temporarily suspended for President Obama in 2015 as part of a complex budget deal.
The debt is sitting at its ceiling of about $20 trillion. The Federal Government needs to borrow an extra approximately $1 trillion every year to meet its current mandated spending requirements. Therefore, the debt ceiling must be raised by Congress and soon…mid-October is the latest estimate.
In addition to rolling over maturing debt, the Federal Government has continued to issue new debt despite the debt ceiling by using its cash on hand to pay down the debt it owes to Social Security, government and military pension funds. Paying down this internal debt has made room to issue more public debt. This arrangement has allowed the Treasury to project the illusion of normalcy by maintaining a regular schedule of new issuance although the amounts have been declining.
Thanks to a sizable increase in June tax collections, the Treasury has been able to keep the game going longer than I expected. However, the grace period comes to an end in October when a large payment is legally required for the military pension fund. Furthermore, the October deficit is normally over $100 billion. The ceiling will have to be raised or the government will have to be shut down.
Now, obviously with the way things are in Washington, the debt ceiling is unlikely to be raised without a titanic battle and probably a shut down. But that’s not my main concern at the moment. As we move towards the point where the Treasury stops issuing new paper, the markets are going to fill up with cash that would otherwise have gone to the Treasury. That cash does not sit idle; it has an impact on short term interest rates (bringing them down) and markets (goosing them up).
In fact, the interest rate on the 4-week bill is now well below the Fed Funds target rate….proof that the money market has too much cash. The rate could drop even lower if the Treasury cuts the size of this week’s bill offering again as expected. The Treasury could suspend new issuance at any time and will need to do so in the next few weeks. With no new Treasury supply coming to market to absorb cash, the excess money flows into the accounts of dealers and investment funds. That is what happened in October of 2015 in the last debt limit crisis. The markets went on a tear for the month that Treasury issuance was suspended. When the ceiling was removed, the Treasury started issuing paper hand over fist and the mini-boom was followed by a violent selloff beginning in November of 2015 that drove rates up and tanked the equity markets.
A similar scenario could easily occur this fall. This time it could also coincide with actual Fed tightening if the Fed begins selling down its holdings of government and mortgage debt as Yellen announced last month. In my view, the markets are vulnerable due to extreme bullishness and over-valuation. Instead of a one month selloff, the Fed and the Treasury could together trigger the first leg of a bear market.
Just follow the money dear reader. It’s never about anything else.