U.S. Stocks Face Headwinds as Debt Issuance Nears 100% of Deficit

Historical data reveals a significant correlation between the issuance of U.S. debt and the performance of U.S. stocks. When the net issuance of medium to long-term debt approaches or exceeds 100% of the fiscal deficit, the stock market tends to stagnate or decline. This pattern has been observed in several instances, including 2008, 2010, 2015, 2018, 2022, and the current period, encompassing nearly every major stock market downturn since the global financial crisis, excluding the pandemic.

Currently, the net issuance of medium to long-term U.S. debt is close to 100% of the fiscal deficit, with long-term debt net issuance at 80%. However, the overall growth rate of government debt issuance is slowing down. This combination, described as a "reverse golden rule," presents a challenging scenario for the stock market. The "crowding out" effect of medium to long-term debt issuance on market liquidity is stifling the upward momentum of the stock market, while the growth stimulus from the fiscal deficit is insufficient to offset this impact.

Data indicates that when the net issuance of medium to long-term debt exceeds 85% of the fiscal deficit and the total issuance growth rate declines, the S&P 500 index performs significantly below average over the next 1-12 months. This suggests that the market is currently in an unfriendly fiscal environment, making it an unfavorable time for investment.

In 2023, the U.S. Treasury successfully implemented a strategy of increasing short-term debt issuance to inject liquidity into the market. This move allowed the market to absorb excess reserves from the Federal Reserve's reverse repurchase (RRP) facility, filling the fiscal deficit while maintaining liquidity. As a result, the proportion of long-term debt issuance decreased, and the stock market entered a two-year bull run. The success of this strategy highlights the potential for short-term debt to support the market in high-deficit environments.

However, increasing short-term debt issuance is not without risks. The current U.S. Treasury Secretary has criticized the previous administration's short-term debt strategy, citing increased interest costs and inflation risks. Additionally, the total interest expenditure on U.S. debt has surpassed 100 million dollars annually, and further shortening the average debt maturity could exacerbate inflationary pressures. Analysts also warn that increased short-term debt issuance could heighten volatility in the fixed-income market and steepen the yield curve, leading to further interest rate fluctuations.

The relationship between government debt issuance and stock market performance is influenced by the repo market, which has seen explosive growth in recent years. Advances in collateral valuation systems, clearing mechanisms, and liquidity have made repo transactions more "money-like." Government bonds are no longer stagnant assets but are frequently repurchased at low discounts in highly liquid markets, enhancing their velocity. This dynamic has strengthened the positive correlation between government debt issuance growth and stock market performance, particularly in the context of total issuance rather than net issuance.

The repo market's preference for newly issued debt, coupled with the ineligibility of near-maturity debt, creates a scenario where short-term debt supply is insufficient to offset the liquidity drain caused by long-term debt. Meanwhile, the overall issuance growth relative to the fiscal deficit is weak. This imbalance underscores the complex interplay between debt issuance, market liquidity, and stock market performance, highlighting the need for careful management of the debt issuance structure by the U.S. Treasury.