Market Memo: Let's talk debt ceiling...again

09-05-2017

With only a dozen or so working days left when Congress returns from recess, legislators will have to work fast to keep the federal government operating when the new fiscal year begins on Oct. 1. Without an approved budget that authorizes spending, it will be forced to shut down, providing only essential services. We have been faced with shutdowns many times, with the most recent lasting 17 days in October 2013. While politically unappealing, these episodes actually do not threaten the Treasury Department’s ability to issue and repay debts.

The more critical issue to those operating within the markets is the debt limit, the amount of debt Congress authorizes the federal government to issue. The Treasury has hit the $19.8 trillion allotted for 2017 and is operating with the use of extraordinary measures, which are expected to run out in early October. Although the debt ceiling is separate from a shutdown, the two often are linked in the minds of the public and investors because the debt limit is useful leverage for politicians negotiating spending bills.

Ultimately, we do not believe the Treasury will be forced into technical default. Treasury Secretary Steven Mnuchin and congressional leaders have pledged to take whatever steps are necessary to raise the debt ceiling. But we understand investors may be concerned by headlines. We expect either a short-term deal that pushes the issue off for a few months or a longer-term agreement. But short-term markets have begun to reflect concern, with early October Treasury bill yield 10-15 basis points higher than surrounding maturities.

If a deal isn’t struck, the Treasury still has options to avoid a default. It will be able to continue to operate with the cash balance it has on hand, projected by most analysts to keep it functional until early to mid-October. The Treasury also has the ability to roll over maturities of certain types of short-term securities, such as T-bills, under the existing debt limitations, and to prioritize payments on obligations. That said, we have been shying away from Treasury coupon-bearing securities that mature within this period: not because we believe they will default, but because we understand our shareholders may perceive a risk in those holdings. It is only prudent to do contingency planning.

We have found most of our client concerns are liquidity and price volatility. In past debt-ceiling episodes we have proactively raised liquidity levels for an added buffer in the event of prolonged market dislocations. We would expect to make the same decisions this time. To the extent we become uncomfortable with the market, we could to boost our usage of the Fed’s reverse repo facility or hold investments in cash. Very short-term Treasury bills have exhibited some volatility in past debt-limit fights, but we have the tools to mitigate the effects on our portfolios. Volatility’s impact on a money fund’s net asset value (NAV) from an increase in yield falls well short of what would be necessary to challenge the stability of principal.

Even in the very remote circumstance of a default on a Treasury security, SEC Rule 2a-7 would not require a fund to dispose of that security. Rather, its board could—and in all likelihood would—determine it would be best to hold the security given the certainty of eventual repayment in full. Furthermore, there are no cross-default provisions in Treasury securities; a technical default on a Treasury security that has, say, an Oct. 15 maturity date or coupon payment does not automatically mean that all Treasury securities are in default. Other Treasury securities could still be considered eligible for money funds.

Lastly, we have found Treasury and market participants quite resourceful in term of devising plans that would allow even securities threatened with default to continue to trade in the market, thereby mitigating the effects the challenging circumstances.