Douglas Rissing
By AJ Rivers, CFA, FRM, CAIA and Lucas Krupa
US Treasuries have long been considered a safe haven for investors – a go-to refuge in turbulent times and the bedrock of global financial markets. That’s because Treasuries are highly liquid and are backed by the full faith and credit of the US government, which has never defaulted in all its 247 years.
Nonetheless, investors tend to get jittery when the US Treasury borrows more than Congress has authorized. That happened in mid-January when the federal government breached the statutory debt ceiling, which currently stands at $31.4 trillion. While the government has not technically defaulted, the risk of default – even if unintentional – has escalated significantly.
Fortunately, the Treasury Department has taken “extraordinary measures” – primarily in the form of accounting sleight-of-hand – to keep the federal government solvent, and we believe that there is little risk of an actual default before September.
But kicking the can down the road doesn’t rule out potential minefields for investors in the meantime – particularly in the short-term markets.
X Marks the Spot
The primary issue at hand is the “X-date” – essentially, the point of no return. If Congress fails to raise or extend the debt ceiling before the X-date, the US Treasury would lack authorization to issue more debt and could technically default on its existing obligations.
It’s a worst-case scenario, and one we don’t believe will come to pass. But it’s still enough of a threat to make Treasuries maturing on or around the estimated X-date inherently riskier.
This, in turn, has the potential to ratchet up market volatility in short-term markets – particularly as we get closer to the as-yet-unknown X-date without a resolution on raising the debt ceiling.
Notably, a US government “default” is not a typical variety of default. In this case, interest and principal on “defaulted” maturities would get delayed or extended and paid once the debt ceiling is resolved.
Investors not concerned with delayed payments would then jump in and buy these maturities to take advantage of any spread widening (typically 30–50 basis points) and help stabilize the market (Display).
What Could Prompt an Increase in Volatility?
If the continued political standoff over raising the debt ceiling turns from weeks to months, investors could see volatility take on several forms.
First off, the US Treasury will run its Treasury General Account – think of this as a checking account – within a tight range to not breach the debt ceiling between now and the X-date.
This means that in months when the Treasury needs to raise cash (February tax-refund season), it will aggressively issue T-bills in a short window of time. Conversely, when the Treasury needs to reduce cash (April tax receipts), it will need to aggressively pay down T-bill maturities. This could increase rate volatility and adversely affect funding markets.
An imbalance between Treasury supply and the amount of cash available could cause repo (short-term) rates to rise and create temporary dislocations in liquidity or funding. This is akin to being caught with too much collateral and not enough funding.
That’s to say nothing of headline risks and broad-based market volatility that could flare up if Congress decides to use the debt ceiling as a political football. If there’s one thing investors don’t like, it’s uncertainty. Until there is further clarity, investors are likely to trade around the anticipated X-date by purchasing securities that mature outside of that window.
For the moment, though, time is on investors’ side and there’s plenty of excess cash in the system. The Federal Reserve’s Reverse Repo Facility (RRP), which the Fed uses to soak up excess cash, can be viewed as a barometer of sorts. It’s currently flush to the tune of $2.1 trillion (Display).
Until the RRP is drained, we wouldn’t anticipate much in the way of near-term funding issues. Even if disruptions were to occur in the coming months, we’d expect them to be temporary.
Quantitative Tightening Could Upset the Balance
Even though there’s sufficient cash today, however, that could change with reductions in the Fed’s balance sheet. As part of quantitative tightening, the Fed originally intended to unwind its balance sheet by roughly $95 billion a month by maturing $60 billion of Treasuries and $35 billion in mortgage-backed securities.
If that happens (so far, the Fed has been falling short of that pace), it could mean that when the X-date comes around later this year, the Fed may have injected up to $950 billion in securities back into the market.
While a sudden influx of net T-bill issuance would fund the government, when combined with quantitative tightening, it may overwhelm the markets with supply, pressuring funding levels (Display).
Dealers, already squeezed by regulatory requirements, will need to fill the Fed’s void. To ease funding pressure, the Fed has implemented a Standing Repo Facility to provide primary dealers with cash should they run into trouble. This should prevent funding rates from spiking as they did in September 2019.
Once the debt ceiling is resolved, the US Treasury will want to replenish its Treasury General Account back to $500 billion and make good on delayed payments from current extraordinary measures.
At that point, we could see the Treasury Department aggressively issuing securities and dislocating funding markets with too much collateral. But at least the risk of default will be gone by that point.
In the meantime, all eyes are on Washington as the perils of divided government play out for the world to see. The X-date is still unknown, and any number of scenarios could unfold before then. The sooner the two parties can come to an agreement, the faster Uncle Sam can resolve this latest in a long line of market disruptions.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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