US debt ceiling deadline disrupts T-bills markets

UBS reckons the US debt ceiling will likely be raised at the end of September when the fiscal year ends and the 2018 budget signed off but warned that timing is critical for the short-term money market.

Whether Treasury bills are issued before and after the deadline matters a great deal to markets. Congress must raise the national debt ceiling by October or the federal government will run out of money, according to the Congressional Budget Office.

“If the debt limit is not increased above the amount that was established on March 16, 2017, the Treasury will not be authorized to issue additional debt that increases the amount outstanding,” the CBO said in a recent announcement.

“That restriction would ultimately lead to delays of payments for government programs and activities, a default on the government’s debt obligations, or both.”

Currently, the debt limit is $19.8 trillion. The CBO said the US faces a projected budget deficit of US$693 billion by October, about US$134 billion more than its most recent estimate, amid “surprisingly weak tax collections” and larger subsides for government programs.

Urgent action

The Treasury Secretary, Steven Mnuchin, has urged action before the August recess, calling for a “clean” increase. The Freedom Caucus, a group of conservative and libertarian Republican members of the House, has rejected that call.

“We do not think that a default is at all likely, but it has to be considered as a tail risk at this point,” said UBS economist Seth Carpenter. “Republicans control both houses of Congress and the White House and it is not remotely in their interest to default. Default would put us into the territory of unknown unknowns, to put it mildly. Major market disruptions would be likely."

Broadly, the UBS view is that the debt limit will be raised in conjunction with appropriations legislation at the end of September.

“Some sort of legislation must pass - whether an actual budget or a continuing resolution,” Carpenter said, adding that there is a “well-trod path to raise the debt limit in conjunction with that type of legislation.”

On balance, UBS is putting put another 20-25 per cent probability that it will be raised as a standalone measure in August. The residual probability is a significant misstep.

The path to raising the debt limit is the issue, according to the economist. If the debt limit is raised well before the deadline, he argued, the effect will be minimal and he would expect Treasury bills to cheapen to the Overnight Index Swap rate as the Treasury will ramp up T-bills issuance.

“If debt limit negotiations are protracted, expect a richening in Treasury bills, particularly those that mature before the drop-dead date in mid-October," he said. “A second-order effect - if negotiations come down to the wire and there becomes uncertainty about the timely repayment of bills maturing around the drop-dead date - would be an acute cheapening of specific issues.”

Money-market reforms

The broader issue for the market, however, is that T-bills are already undersupplied relative to demand following money-market reforms. Three-month T-bills are trading 14 basis points rich to OIS.

“This richness would increase,’ Carpenter said.

As debt limit negotiations move closer, UBS is advising clients to take the opportunity to fade the relative richness of 3-month T-bills to OIS.

Since March, when the suspension of the debt ceiling expired, the Treasury has been using "extraordinary measures" to continue business roughly as usual. For instance, federal employees can invest in government securities in their thrift savings plan.

This ‘non-marketable’ debt counts against the statutory limit. Treasury can replace the non-marketable debt in the thrift plan with special IOUs that do not count against the limit.  The Treasury keeps track of this "under-investment" and after the debt limit is lifted, the non-marketable debt is restored.

“This type of adjustment is entirely legal and has been reviewed by the Government Accountability Office a number of times, even though if a private company was doing it, it would raise eyebrows," he said.

“The Treasury uses the legal options at its disposal, but they have limits. If, through miscalculation or misunderstanding, the debt limit is not raised when both the cash and accounting devises are exhausted, the Treasury would have to default on its obligations.”

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