Market Memo: Here we go again
Although the market breathed a sigh of relief at the end of the year when the economy avoided the plunge off the “fiscal cliff” some had feared, the short-term deal reached by Congress and the Administration laid the groundwork for a series of political showdowns to take place in the first quarter of 2013.
We have been here before, in the summer of 2011, and just as in that case, we consider the probability of a technical default by the Treasury to be virtually nonexistent. We are confident that the debt ceiling will be raised before the Treasury exhausts the extraordinary measures it has at its disposal to meet the financial obligations of the federal government.
Three deadlines now loom on the horizon: On March 1, the automatic spending cuts dictated by the Budget Control Act of 2011 will kick in. On March 27, the continuing resolution that allows the federal government to continue functioning will come to an end. And sometime in late February to mid March—depending on what happens during tax filing season—we will come to a point at which the Treasury does not have the funding to pay its bills. While all three are important, the Treasury’s ability to make payments on its debt is the most critical to investors in the market. Treasury Secretary Timothy Geithner affirmed that the Treasury had reached the debt ceiling on Dec. 31, 2012 and were now employing “extraordinary measures” to meet the nation’s financial obligations. Of course we’ve now gotten a three-month extension of the suspension of the debt ceiling through May 18, but it’s just a small kick to get the proverbial can down the road — no one has yet addressed the underlying ideological dispute over how to balance spending and revenue. In the months to come we would expect the headlines surrounding this issue to intensify, and the willingness of some in Congress to use the debt ceiling as leverage in order to achieve a desired political outcome to grow. In other words, it’s likely to get messy.
No matter how unlikely the occurrence, this latest showdown has begun to raise some market speculation as to what a technical default might mean to money market funds that hold Treasury securities, so we wanted to revisit some of the basic questions surrounding this issue.
First, Securities and Exchange Commission Rule 2a-7, which governs money market funds, does not require that a fund dispose of a security that is in default. Rather, it permits the fund to continue to hold such a security, provided that the board of directors of the fund has determined that disposal of the security would not be in the best interests of the fund. Rule 2a-7 indicates that such determination may take into account, among other factors, market conditions that could affect the orderly disposition of the security. Given the expectation that any potential technical default on Treasury securities would be very short-lived, it is possible that a fund's board could make the determination to continue to hold the security.
Second, although all short-term securities might exhibit some degree of volatility during this time, we would expect the market reaction to remain substantially below the threshold which might exert significant downward pressure on the net asset values (NAVs) of money market funds. All things being equal, it would take an instantaneous increase in rates on short-term securities of approximately 300 basis points before the NAV of a money market fund with a 60-day average maturity would be in danger of breaking a buck. Such an extreme market overreaction is hard to imagine.
Finally, Federated’s money market funds are absolutely committed to maintaining liquidity to meet the needs of their shareholders in the event that a fiscal reform package or an increase in the debt ceiling is delayed. Rule 2a-7 already requires money market funds to maintain stringent minimum liquidity buffers for daily and weekly liquidity needs. Federated would expect to continuously evaluate the potential liquidity needs of its money market funds and augment their existing liquidity position with greater daily or weekly positions, cash balances or alternate liquidity sources should it appear necessary if the conflict continues.
We wouldn’t be surprised if the players on both sides in Washington take us right to the edge of yet another cliff in an effort to play this out for short-term political advantage, but we also think that someone will blink at the last minute—no one wins when systemic risk in the global financial markets is unleashed. While we believe that political brinkmanship will give way to the hard realities that a failure to raise the debt ceiling would pose to the United States, we are diligently working to prevent this showdown from undermining our primary goal: providing clients with a stable source of cash management.
