Look past headline risk, seek out high-quality credits, and position maturities for a possible default “X-date.”
Lance Pan, CFA
Once again, it’s time for CFOs and corporate cash investors to start focusing on another debt ceiling showdown in Congress. In a January 19 letter, Treasury Secretary Janet Yellen declared that the United States had reached its statutory debt limit of $31.381 trillion. As Congress failed to authorize more borrowing in time, a “debt issuance suspension period” began immediately and the Treasury Department started using “extraordinary measures” to keep the government funded through June 5th, 2023.
The debt limit debate is nothing new. For the last decade or so, what used to be a routine Congressional procedure turned into high-stakes, down-to-the-wire political drama that catches the public’s attention. In 2011, the drama resulted in a credit-rating downgrade by Standard & Poor’s to AA+, the first time the U.S. federal government was given a rating below AAA. As in past showdowns, the unimaginable consequence of a default, even a technical one, resulted in the limit being lifted at the last minute—but not without lingering concerns that complacency and bitter politics might lead to self-inflicted wounds too grave to heal in the next round of fight.
We believe that politicians will again come to their senses and authorize spending in time. Or, should they fail to reach an agreement, the Treasury Department may work with the Federal Reserve to prioritize payments on debt obligations to avoid a default. These “extra-extraordinary measures” would most likely be temporary and politically distasteful but might create an additional incentive for Congress to authorize new spending limits. Nevertheless, given the high stakes and high degree of conflict in Congress this time around, liquidity investors are well-advised to pay attention.
Questions confronting institutional cash investors
CFOs and institutional cash investors have tools at their disposal to contend with possible consequences of the current debt limit showdown. Reviewing past playbooks and coming up to speed on the details of the situation today—especially looking past headline risk toward the possible timing of the default X-date—can help investors position their portfolios for this year’s uncertainties.
Following is a primer with answers to some common questions on investors’ minds, along with advice on possible strategies for cash portfolio managers.
What’s the debt limit and why does it exist?
The debt limit is the maximum amount the US government can borrow to pay its bills. Because the government runs budget deficits, it must borrow money to pay these bills. Congress must authorize borrowing according to the Constitution.
The debt limit—often referred to as the debt ceiling—was first instituted in 1939 by legislation requiring the Treasury Department to ask for permission to issue debt. A simple majority in the House and Senate is required to lift it. Originally designed as a check against overspending and over-taxation, the debt limit has been raised 102 times since 1945.
Why is raising the limit so difficult?
Raising it was a routine procedure in Congress for several decades. As the political environment become more polarized, brinksmanship over the debt ceiling also increased. In recent episodes, members of Congress waited until after the limit was reached and the Treasury Department was about to exhaust the extraordinary measures before resolving the issue.
In the 2011 standoff between Democratic President Barack Obama and House Republicans, credit rating agency Standard & Poor’s knocked the US government debt off the coveted AAA rating.
Why is the market particularly concerned this time?
Republicans holding a slim majority in the House are refusing to raise the limit without a guarantee from the Biden administration to cut back on spending. The White House refuses to tie raising the limit to spending cuts. This political posturing is not new.
What is new, however, is that in winning votes from members of the conservative Freedom Caucus, Speaker Kevin McCarthy (R-CA) conceded to the rule that a single member of Congress could force a new speaker election. He also agreed to their demand of naming deficit spending as a top priority. This means that if one member forces a new speaker election, all house business including the debt limit legislation must stop until a new speaker is elected. Despite signs that Biden and McCarthy are warming up to “honest debates,” leadership in either party may have little control over a rogue representative who forces a speaker election and throws Congress in limbo.
In past debt-limit showdowns, heated rhetoric of political maneuvering created daily news-cycle headline risk that drove significant fluctuations in market averages. Our advice to cash investors then was to look past the daily headlines and focus on likely scenarios for an ultimate resolution. Our current expectation is that, given the potential economic catastrophe resulting from actual default, Congress will ultimately come to an agreement to lift the debt limit as it has in the past. Nevertheless, we beieve that liquidity investors should consider establishing portfolios with laddered maturities and high-quality credit instruments to weather the ups and downs of a market buffeted by the daily headlines.
What are the “extraordinary measures” and how long can they last?
In her letter to Congress, Secretary Yellen said the Treasury Department will no longer invest funds for certain federal health and retirement plans, including suspending the daily reinvestment of securities held by the Treasury’s Exchange Stabilization Fund and temporarily moving money between government agencies and departments. By redirecting investments and payments meant for its internal accounts, these measures create more headroom to satisfy public debt payments without hitting the limit. Once new borrowing is authorized, the government can replenish those accounts under its control. These extraordinary measures may allow the department to procure some $800 billion additional funds to keep the government going for some time.
What is the X-date, when will it be reached, and what does it mean for cash investors?
Secretary Yellen said that extraordinary measures could be exhausted by June 5th. This X-date is the date that the government may literally run out of cash and is unable to issue new debt and pay its bills, including interest to bondholders, payroll checks to government employees and military personnel, and social security checks. Beyond this point, a technical default of the government debt becomes possible.
However, there is considerable uncertainty around the X-date, which depends both on the amount the government spends and the receipt and timing of its tax revenue. Although the Treasury Department’s estimate is June 5th, market strategists place their projections anywhere between August (Barclays) and November (JPMorgan). Bank of America estimates late summer or early fall.
Why is the X-date important for CFOs and other managers responsible for corporate cash investments and liquidity? You can expect yields to increase on Treasury securities that mature around the X-date as it approaches. Therefore, we advise cash managers to consider selective investment in high-quality securities with longer maturities. Locking in future returns on higher-yielding securities before a flight to quality increases demand and lowers their yield, might make sense for many portfolios.
What happens if the government defaults on its debt?
If Congress fails to act, the government may be forced to default on its debt obligations for the first time in history. The event not only would shake investor confidence in US government bonds, raising the prospect of a US recession, global market volatility and reduced liquidity, but also threaten the reserve currency status of the US dollar, invite more ratings downgrades, and likely raise borrowing costs. Missed payments on other U.S. obligations, including Medicare and Social Security benefits, could cause tremendous economic pain on individuals and businesses.
What can the Treasury Department do to avoid defaulting on its debt?
The Treasury Department in the past had a plan for “extra-extraordinary measures.” During the 2011 debt limit debacle, an idea emerged that the Treasury could give priority to certain outlays over others and thus avoid defaulting on debt payments. Past Treasury officials called such a plan unworkable, but the transcript of an August 2011 private meeting between Federal Reserve and Treasury officials revealed that a plan was indeed formalized to make on-time payments on Treasury debt and delay paying other bills should the debt limit talk fail.
This revelation underpins rating agencies’ confidence that the US would not immediately default on its debt, as Moody’s “believes that the Treasury would prioritize interest payments over other expenses to preserve the full faith and credit of the US government and avoid significant disruptions to global financial markets.” By paying bondholders first, the Treasury could theoretically forestall a financial market disaster.
But as the government runs a budget deficit, those “extra-extraordinary measures” would only be a stop-gap solution. They also could be logistically cumbersome, and in choosing to pay foreign debtholders over domestic workers, soldiers, retirees, and healthcare systems, they could prove to be politically disastrous.
Can the Federal Reserve do something about it?
By law, the Federal Reserve cannot lend directly to a federal department. Fed officials also avoid discussing the debt limit to preserve its independence from the legislative process and partisan politics. The central bank, however, has several options to mitigate or lessen negative ramifications from the threat of a default.
As noted earlier, should the Treasury decide to prioritize payments, the Fed will be tasked to “pend” them in its electronic funds transfer system. As more transactions move online, the task gets easier for the Fed to track and manage them. The Fed may also purchase Treasury securities that mature around the X-date to take them out of money market and retirement funds to preserve market liquidity and stability. It could also accept them as collateral for repurchase agreements. In the unlikely event of a default, it could even purchase defaulted securities outright or swap them for non-defaulted ones, albeit at reduced market prices, to keep the market functioning.
The downside for the Fed to get involved, besides political ramifications, includes the moral hazard of bailing out the government that makes future fights more frequent and lasting longer. For these concerns, the Fed likely will stay on the sideline unless as a last resort.
How should liquidity investors prepare themselves during this period?
We believe liquidity investors may benefit from following strategies that worked in previous debt ceiling episodes. They should not be overly concerned with the headline risk but instead be vigilant on the timing of the X-date. Although we are confident (but not blindly so) that the debt limit will be lifted in time and a default avoided, we recommend that investors consider a liquidity portfolio with laddered maturities and high-quality credit instruments, as market liquidity may be choppy as investors process the highs and lows of the negotiations.
With past experience as a guide, investors should remain calm as negotiations are underway and not give in to the temptation of reacting to the 24-hour headline coverage. Expect yield on Treasury securities that mature around the X-date to rise as the X-date approaches, and selectively invest in securities of longer maturities, as their yield may go down as the flight-to-quality trade is underway.
Liquidity investors should review their portfolios with their investment advisors, repurchase agreement counterparties, and money market fund managers to limit exposure to securities with at-risk maturities, and refrain from buying securities “on the cheap” near the X-date.
 See the Depart of Treasury’s press release, Secretary of the Treasury Janet L. Yellen sends letter to Congressional Leadership on the debt limit, January 19, 2023, https://home.treasury.gov/news/press-releases/jy1196.
 See the White House press release Remarks by President Biden at the U.S. conference of mayors winter meeting, January 20, 2023, https://www.whitehouse.gov/briefing-room/speeches-remarks/2023/01/21/remarks-by-president-biden-at-the-u-s-conference-of-mayors-winter-meeting/.
 Kate Davidson, Officials planned to prioritize debt payments as 2011 debt-ceiling deadline loomed, The Wall Street Journal: Economy | Central Banks, January 12, 2017, https://www.wsj.com/articles/officials-planned-to-prioritize-debt-payments-as-2011-debt-ceiling-deadline-loomed-1484257028.
 Moody’s: FAQ on US Government’s debt limit and potential sovereign rating implications of a missed interest payment, November 16, 2021, https://www.moodys.com/research/Moodys-FAQ-on-US-Governments-debt-limit-and-potential-sovereign–PBC_1311160. Subscription required.