Wall Street Fears $1 Trillion Aftershock From Debt Deal

Looming behind market fears over the prospect of a historic US default is the less-discussed risk of what would follow a deal to resolve the debt-ceiling impasse.

Many on Wall Street predict lawmakers will ultimately reach an agreement, likely averting a devastating debt default, even if it goes down to the wire. But that doesn’t mean the economy will escape unscathed, not just from the bruising standoff but also as a result of the Treasury’s efforts to return to business as usual once it can ramp up borrowing.

Ari Bergmann, whose firm specializes in risks that are hard to manage, says investors should hedge for the aftermath of a Washington resolution.

What the market veteran is getting at is that Treasury will need to scramble to replenish its dwindling cash buffer to maintain its ability to pay its obligations, through a deluge of Treasury bill sales. Estimated at well over $1 trillion by the end of the third quarter, the supply burst would quickly drain liquidity from the banking sector, raise short-term funding rates, and tighten the screws on the US economy just as it’s on the cusp of recession. By Bank of America Corp.’s estimate, it would have the same economic impact as a quarter-point interest-rate hike.

Higher borrowing costs in the wake of the Federal Reserve’s most aggressive tightening cycle in decades have already taken a toll on some firms and are slowly crimping economic growth. Against this backdrop, Bergmann is especially wary of an eventual move by Treasury to rebuild cash, seeing the potential for a massive reduction in bank reserves.