The looming debt ceiling and a possible, though unlikely, technical default in the Treasury bill market has been a major topic of conversation in the money markets over the past week. Bank of America Merrill Lynch is the latest to weight in on the discussion, with a "Liquid Insight" entitled, "Debt limit and government shutdown FAQs." We excerpt from this update, as well as from a recent release from Citi, below. We also briefly look back at Crane Data's coverage of previous episodes of debt ceiling showdowns.
BofA Merrill's Mark Cabana, Adarsh Sinha and Yang Chen write, "September is fraught with political risk in the US: Republicans need to deliver details on their long awaited tax plan, Congress has to raise the debt limit, and a new budget needs to be passed to avoid a government shutdown. These risks have increased as President Trump threatened a government shutdown and called the debt limit approval process "a mess". This focus has resulted in numerous client questions on the debt limit and government shutdown, which we address in this note."
They tell us, "Our baseline is for both the debt limit and government funding to be resolved in a timely manner, but further volatility is likely. This is especially true since there are only 12 joint congressional working days after lawmakers return from their summer recess on 5 September. Markets are already showing early signs of concern around the debt limit despite Republican control of the White House and Congress.... We address frequently asked questions on the debt limit and government shutdown given our expectation that US political risks will likely rise in the weeks ahead."
BofA explains, "The debt limit and government shutdown are two distinct and separate issues. The debt limit is the total amount that the US government is authorized to borrow and is legally determined by Congress. The debt limit was reinstated as of 15 March this year at the level of $19.8tn and the US government has been operating using extraordinary measures or accounting maneuvers, which we forecast to last until 1H October.... A government shutdown occurs when Congressional appropriations expire and there is no approved budget that authorizes federal spending."
They write, "Debt limit episodes typically have had the largest impact on the Treasury bill market and coupon securities with impacted principal or interest payments. Treasury bills are typically the "canary in the coal mine" for the debt limit since they mature with greater frequency around the "X" date and holders are subject to delayed payment risks. There is a distinct hump in the Treasury bill curve for October maturities and these issues trade cheap to surrounding issues by as much as 14bp. It is unusual to see such an early market response and this likely reflects (1) government MMF risk aversion and larger footprint in the bill market post 2a-7 MMF reform ... and (2) the market is anticipating a challenging resolution. Treasury coupon securities with mid-October interest payments are also showing signs of cheapening in relation to surrounding issues, though price action has been less pronounced versus bills."
The piece adds, "The debt limit also has implications for Treasury supply, especially at the front end of the curve. The Treasury is currently in the process of dropping their cash balance to meet outstanding obligations and cutting bill supply to ensure there is enough debt limit headroom to settle new coupons. Once the debt limit is resolved it is expected that the Treasury will quickly increase its cash balance through a rebound in bill issuance that could total $380-400bn over 4Q. As we wrote here, this supply should cause bills and agency discos to cheapen, front end swap spreads to narrow, repo to shift higher, and could place modest upward pressure on short-term unsecured borrowing costs."
Citi's latest "Short-End Notes" features a brief entitled, "Walls, ceilings and boxed in." It says of the Debt ceiling, "The dislocation in the bills curve can continue, though we give very little likelihood of the government default. Money market funds have been rebalancing their portfolios but further adjustments are likely to be made as we get closer to the X-date."
Steve Kang writes, "The premium of Oct bills over Sept/Nov has widened by +10bp this week due to mostly antagonizing remarks over the shutdown and the debt limit. The dislocations are getting closer to the levels we saw back in 2013. We saw growing disruptions in 2011/2013 episodes but it was much more muted in 2015, as the market expected (1) eventual resolution under the previous leadership and (2) the deal was reached in about a week prior the announced X-date, stopping the dislocation before growing exponentially. We also see dislocations earlier as the market expects disruption from the debt limit impasse over the years. Uncertainty over the new administration seems to be catalyzing this earlier move. The dislocation can grow larger from here, as further 2a7 rebalancing is likely (more on this later)."
Citi explains, "This year, we think dislocation of Oct bills can be more severe given the larger Gov MMF AUM due to the reform in 2016. Looking at the monthly 2a7 portfolio data at the end of July from Crane, we do see that US money market funds decreased the share of bill holdings in Oct maturities and barbelled their purchases to hold more Sept/Nov issues.... Even with some decrease in share, MMFs still owned a sizable amount of October bills at the end of July (63bn, or 20% of total outstanding), even as Oct bills sold off by 10bp during July. Given that MMF community started clearing up at-risk bill issuance just 2-3 weeks going into the reform, we may see further sales going forward. Of course, some of that dynamic may be behind us since the data is as of end of July."
For more on past episodes and commentary on debt ceiling showdowns and the potential impact of a technical Treasury default on money market funds, see the following Crane Data articles: "Bloomberg writes 'Money Funds' Risk Rises Over Debt Cap Debate'" (7/27/11), "More Debt Ceiling" (7/22/11), "Fidelity's Huyck Comments on Debt Ceiling Countdown, Answers FAQs" (8/1/11), Fitch Writes Money Market Funds: What a U.S. Default Would Mean (7/19/11), "AP writes "With risk of debt default allayed, money funds remain safe bet" (8/8/11), "ICI on S and P Downgrade, Reviews Flows During Debt Ceiling Debate (8/8/11), "Strategists on Treasury Debt Ceiling; SEC Stats on Liquidity Funds (10/19/15).
