Remember the debt ceiling fights of 2011 and 2013? They may be in the back of many investors’ minds now, but will likely be front and center again leading up to March 15, when the suspension of the federal government debt ceiling expires.
Any institutional cash investor who lived through those earlier Congressional standoffs knows how such political swashbuckling can disrupt U.S. sovereign debt markets. Both battles eventually were resolved amicably, but at the time, many investors still chose to step away from Treasury securities that matured near projected technical default dates.
The federal debt limit has been suspended since late 2015, but the law is set to be reinstated on March 16. If federal debt exceeds the current limit of $20.1 trillion at that time, Congress will have to vote to raise the debt limit again or risk default.
Debt Ceiling Crisis in Three Acts
Following the Republican sweep in Congress and election of a Republican President, we have a new political order. But don’t be surprised if we experience another rollercoaster ride anyway. Even a tamer replay of the political brinkmanship of 2011 and 2013 may be complicated by the large presence of Treasury money market funds, presenting challenges for cash investors.
If history serves as a guide, a new debt ceiling drama could be expected to unfold in three acts.
- Act One: Without a new agreement, Treasury must aggressively spend its roughly $390 billion cash balances down to $25 billion by March 15. The street estimates a reduction in Treasury Bills issuance ranging from $125-180 billion during this period.
- Act Two: With a debt ceiling back in place, Treasury could be expected to employ “extraordinary measures” to keep the government running. In that case, it would cease issuance of debt to government entities and halt reinvestments in the “G fund” to return to $300 billion borrowing capacity. Due to tax refund schedules, federal spending tends to be back-loaded in the second half of the year as spending picks up and revenue flattens out. If the debt ceiling fight wore on, Treasury would face increasing pressure for more funding capacity.
- Act Three: We would potentially see the drama conclude with the re-suspension or an increase of the debt ceiling. At that time, Treasury could restock its precautionary cash balance to $300 billion. Based on the projected 2017 federal deficit, Treasury expects to have a net borrowing need of $650 billion for the year, $230 billion of which would be from the supply of new Treasury Bills. All in all, we could expect to see a net increase in supply of Treasury Bills. But how the Treasury Department manages through this rollercoaster ride will be further complicated by the more than $1 trillion net new demand resulting from 2016 money market fund reform.
Potential Crisis of Confidence in Treasury Money Market Funds
Last year’s environment was accommodative to government money market fund supplies. The Treasury Department proactively increased the supply of Treasury Bills, and the Federal Reserve made available up to $2 trillion in balance sheet capacity through its reverse repo (RRP) facility. If we face a debt ceiling fight in 2017, supply alone may not be a big issue as the Fed’s facility remains open as a last resort.
On the other hand, treasury and government money funds, with $2.2 trillion in net assets at the end of 2016, essentially doubled from their $1.1 trillion position at the end of 2015. If investors behave as they did in the past, they may become wary of government and Treasury funds that hold securities maturing near the March 15 “judgment day.” Some funds may sell these securities outright, and Treasury repos backed by such securities may also be questioned. There is the potential for a crisis of confidence in Treasury money market funds, if only for a brief period. With more than $2.2 trillion at stake, we hope cooler heads will prevail.
Cash investors can hope this round of the debt ceiling fight will be more civilized than previous episodes. Still, how the Treasury Department manages through the ups and downs in Bill supply will impact the demand for the Fed’s RRP, agency discount notes and other government instruments. Although we expect a higher net issuance of Treasury Bills, the yield impact is expected to be on the down side for much of the year.
In later stages of the fight, aversion to certain Treasury Bill offerings may develop. We are uncertain how large treasury money market funds will navigate through these disturbed waters and how their shareholders will react.
Therefore, we would advise investors to store some alternative liquidity in addition to their treasury fund shares. For the more adventurous, this period also may present some yield opportunity in picking up securities that could face technical defaults.
Note: This post is an excerpt from our white paper on the 2017 outlook for institutional cash investors, Trumponomics, Debt Ceiling Rollercoaster and Geopolitics: Three Trends to Watch in 2017.