Debt ceiling discussions underway

An agreement to raise the US debt ceiling remains elusive but investor sentiment has improved after a second meeting between President Biden and congressional leaders.

In prior reports, we have reminded readers that recurring legislative debates over the US debt ceiling are usually accompanied by renewed calls for greater fiscal responsibility.[1]?Subsequent budgets rarely reflect the political rhetoric, which begs the question as to why Congress chooses to revisit the ceiling so often. We are inclined to believe that these types of debates have become a principal means by which the two political parties have a substantive debate over fiscal policy. Unfortunately, they often do so with the proverbial sword of Damocles hanging over their respective heads.

Any failure to raise the debt ceiling is a deliberate decision, akin to opening Pandora’s Box. The scope of subsequent market distress is difficult to predict with precision but is likely to be pervasive and severe. The global financial system has become increasingly integrated in recent decades. The use of government securities as collateral for cash in repurchase agreements, and then rehypothecated in subsequent transactions, has increased. Money market funds and short-term investment vehicles, often funded with Treasury obligations, have supplanted conventional bank accounts as a primary vehicle for household savings. A shadow banking system has arisen to provide home mortgages, private investment capital, and consumer loans, which raises the stakes for Congress to reach a timely agreement.

There is certainly a lot at stake in the debate over the debt ceiling, so it seems appropriate to revisit the topic once again through a series of frequently asked questions.

What is the X-date?

As a reminder, the X-date is the first day on which the Treasury Department has exhausted its borrowing authority?and?can no longer honor all contractual obligations in full and on time. This is the day on which the extraordinary measures - aka accounting maneuvers - are no longer sufficient to meet daily expenditure obligations. Subsequent bills must be paid from current cash flow, which will be insufficient to cover all government spending requirements, thereby necessitating a higher debt ceiling and additional deficit financing.

Why is there so much uncertainty regarding the X-date?

US Treasury Secretary Janet Yellen informed congressional leaders on 1 May that the US government would exhaust its ability to employ extraordinary measures to honor contractual obligations “potentially as early” as 1 June. She reiterated her estimated deadline two weeks later in a subsequent missive to Congress.

The lack of precision is noteworthy but understandable given the volatility of government cash flows. Taxpayers in parts of eleven states were granted extensions for the 2022 tax season due to natural disasters, thereby delaying the receipt of a significant number of personal income tax returns until later this year.

The closing balance of the Treasury General Account is now declining steadily, which raises the possibility that the government’s liquidity position will be depleted before the receipt of quarterly tax payments on 15 June. If the federal government can sustain its operations until then, fresh tax receipts and additional extraordinary measures could extend the X-date until the middle of July or August. Secretary Yellen is unwilling to accept the risk that volatile cash flows will surprise to the downside. Hence, the 1 June deadline.

Have financial markets reacted to the impending deadline?

Yes. On 4 May, the US Treasury auctioned USD50 bn of securities maturing on 6 June. Investors demanded a yield of 5.84% on bills maturing in just four weeks.[2]?The yield was the highest in more than 20 years, demonstrable evidence of risk aversion among investors for securities coming due on or near the X-date. It is worth noting that the US Treasury will need to ‘roll over’ nearly USD650 billion in maturing debt between 1 June and 15 June.

The risk premium associated with the X-date is also evident in the yield differential between Treasury obligations maturing on 30 May versus 12 June

The spread reached 228 basis points before retracing to 190 bps in the wake of the commencement of negotiations between the White House and Congress. Subsequent Treasury bill yields have declined thereafter but remain a bit elevated due to a persistently tight monetary policy by the Fed and an expected surge in T-bill issuance once a debt ceiling resolution is reached.

Has anxiety over the debt ceiling extended to other markets?

The US equity market appears to have taken some comfort from the optimism expressed by congressional leaders after their meeting with the president on Tuesday. The S&P 500 index rallied by 1.2%%, the dollar strengthened, and oil prices rebounded. However, investors seeking protection against a US sovereign default were still obliged to pay an elevated premium for one year protection in the credit default swap market. Historically, equity volatility (i.e. the VIX) does not show signs of stress until the X-date approaches. If the market does not place a high probability on a resolution by early next week we would anticipate equity volatility to move higher alongside T-Bill yields and credit default swaps.

Can the Treasury Department prioritize some expenditures over others?

According to Secretary Janet Yellen, the Treasury’s payment processing systems are designed to make payments in the order in which invoices are presented. Thus, meeting some types of contractual obligations (such as social security payments) but not others (such as payroll) is highly problematic. We believe the Department is capable of prioritizing the payment of interest on the national debt because the Federal Reserve is the Treasury’s fiscal agent and maintains an independent payments processing system for Treasury securities.[3]?In this scenario, Treasury would instruct the Fed to roll forward the maturing securities and pay interest when due at the expense of all other contractual obligations.

Of course, the payment of interest on Treasury obligations, including payments to overseas investors, while simultaneously defaulting on other contractual obligations to US citizens, poses a political risk. Alternatively, the Treasury Department could create a queue for payment liabilities and make payments only when sufficient cash is accumulated to settle an entire day’s liabilities. In either instance, the ramifications would be severe, including a degradation in the credit quality of US government obligations, ensuing litigation, and contraction in economic activity following the suspension of government transfer payments.

Should I be concerned about the liquidity in US money markets?

Money market funds invest in short-term liquid assets and generally pay their investors monthly dividends that reflect prevailing short-term interest rates. They have become increasingly important to US households and often function as an individual’s principal operating account for monthly expenses.

Money market funds which invest exclusively in US government obligations are exposed to the risk of a US sovereign default, however temporary. Fortunately, we believe US money market fund managers have already taken steps to avoid unnecessary exposure to the debt ceiling standoff by reducing exposure to maturities coming due on or about the X-date and by investing more of their assets directly with the US Federal Reserve through its reverse repo (RRP) facility. The RRP balances have already increased, which suggest that portfolio managers are already using this tool to insulate themselves and their investors from excess volatility. The top five money market funds cumulatively held nearly USD600 billion in RRP balances.[4]?Institutional avoidance of exposed marketable short-term Treasury securities is one reason why the yields have risen so abruptly.

Moreover, the Fed created a standing repo facility in 2021 to provide the market with supplemental liquidity during periods of market distress. The central bank accepts Treasury securities as eligible collateral and provides overnight cash in return at yields more or less equivalent to the Fed’s own policy rate. While participation in the facility is limited to eligible banking institutions, the presence of the facility is expected to allow the money markets to function in the still-unlikely event of a temporary default.

If I own an individual short term treasury obligation that matures in June or July, should I sell now?

To the extent the Fed is unable to prioritize the payment of T-bills after the X-date, an investor might experience a payment delay. The duration of the delay will depend on the length of any default, but we expect it would be very short-lived. We believe that short-term Treasury securities will remain marketable but the daily value is likely to be quite volatile as the X-date approaches because the buyer base will diminish. Conservative investors with a limited tolerance for risk and a need for immediate liquidity may wish to consider selling these securities in favor of obligations with a longer duration or an alternative short-term savings vehicle.

Fortunately, the Fed is expected to take the necessary precautions to ensure that the individual Treasury security’s unique identification number is preserved, which would allow the relevant maturity to be rolled forward on a daily basis until the debt ceiling is raised. In that scenario, interest would be paid via the Fed’s prioritization of interest payments.

Investors with a greater risk tolerance and an appetite for higher yields may find value in securities that are less appealing to institutional portfolio managers. These short-term bills will offer high yields but will also suffer bouts of price volatility. They are unlikely to be eligible for collateral postings, which will limit the universe of potential buyers for the duration of any default period.

How should I allocate my fixed income portfolio considering the current stalemate?

While there is still considerable uncertainty about the ultimate outcome, we believe there are a number of steps that investors can take in advance of a last-minute resolution. The yields on short-term Treasuries are still attractive, even if one were to avoid securities with maturities in June and July. They deserve a place in investor portfolios. To the extent a conservative investor seeks greater shelter, there are opportunities available in high-yielding savings products.

Yields on longer-dated securities may move a bit higher in the near term but are more likely to decline as the year progresses in the wake of a debt ceiling settlement. We expect portfolio managers to reposition portfolios in anticipation of a more lenient monetary policy by the Fed in early 2024. In that context, a barbell strategy for fixed income portfolios is appropriate, with a modest pivot toward locking in yields in longer-dated bonds, in our view.

While we retain a preference for investment grade corporate bonds over high yield securities, we believe longer-dated tax-exempt municipal bonds are likely to outperform. Net new issuance of municipals is relatively low, which creates a favorable supply-demand dynamic. Munis are also more insulated from the market volatility that imperils the total return available on lower rated investment grade and high yield corporate bonds, so spread widening at the state and local level should be more constrained.

Can the president order the Treasury to raise the debt limit unilaterally?

This question has arisen more frequently following the president’s declaration that he was considering this option. The US Constitution empowers the Congress to “borrow money on the credit of the United States” and obligates it to “pay the debts.”[5]?However, the 14th Amendment also says that “validity of public debt of the United States…shall not be questioned.” Proponents of executive authority argue that the president must ensure payment of the national debt and may do so through an executive order. We do not expect the president to bypass Congress because it would trigger a constitutional crisis and antagonize legislators with whom he must negotiate in the future. Market reception for new securities issued in such a manner is also highly uncertain.

When the president and Congress resolve their differences and raise the ceiling, what are the potential residual impacts to fixed income?

Whenever the debt ceiling stalemate is resolved, the Treasury will need to replenish its cash account fairly quickly. This is accomplished by selling T-Bills which is estimated to reach nearly USD 1 trillion by year end. The Treasury’s cash cushion also must be increased, which the market estimates could reach around 600 billion by year end from the paltry ~USD 90 billion today. This will remove some liquidity from the banking sector, and potentially increase short term funding rates. The Treasury issued USD 500 billion of bills in approximately six weeks following the 2017-2018 debt ceiling episode, which quickly drained reserves. Not surprisingly, the repo market spiked higher. While the Fed has established a supplemental repo facility to guard against such sporadic moves in funding, the draining of reserves will tighten financial conditions in a late cycle economy. Maintaining higher quality and locking in for longer in fixed income mitigates the potential economic headwinds from the additional drain in liquidity.

Conclusion

While the risks associated with the debt ceiling debate are admittedly higher today than at any time since 2011, the probability of a timely (albeit last-minute) settlement is still our base case. After some acrimonious exchanges in recent weeks, both political parties have arrived at the negotiating table and appear genuinely interested in avoiding a fiscal calamity.

Investors will need to exhibit a higher tolerance for ambiguity in the next two weeks as markets react abruptly to news from inside the Washington Beltway. Fixed income markets tend to react more quickly to political developments than other asset classes, which may explain the uptick in volatility in the short-term Treasury markets. This is not unusual, and we reiterate our long-held view that investors are well-advised to avoid overreacting to media coverage from the nation’s capital.

[1]?Please refer to Debt ceiling déjà vu (20 January 2023) and Another debt ceiling debate (10 March 2023)

[2]?Bipartisan Policy Center, Debt Limit Analysis, 18 May 2023.

[3]?Bipartisan Policy Center, “Prioritization.” 17 January 2023.

[4]?Barclays, Money Markets Monthly Update, May 2023.

[5]?US Constitution, Article I, Section 8.

Co-authored with Thomas McLoughlin, Head of Fixed Income and Municipal Securities, CIO Americas and Leslie Falconio, Head of Taxable Fixed Income Strategy, CIO Americas

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