US debt ceiling and the markets
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The political headlines over the coming days will likely be all about the potential government shutdown as Washington deliberates on a short-term continuing resolution. While a shutdown seems to be a distinct possibility and might cause some volatility in markets, it should not in and of itself materially affect markets too much, and any effects should dissipate upon an agreement. That said, the inability to reach agreement on a short-term continuing resolution sends a worrying message, particularly with the far more dangerous spectre of the debt ceiling ahead. Without a debt ceiling agreement, it looks likely that the US government will run out of cash around October 24th.
With the market beginning to price yet another contentious US political battle, it’s interesting to focus on what happened to rates in the 2011 debt ceiling showdown, and we can reasonably expect that a protracted stand-off would result in similar moves in the front end, with cheapening of “at risk” Treasuries. The market seems to be starting early this time, as we have already seen a mid- to late-October bills sell-off and moderate inversion of the bill curve. Apart from that it’s very challenging to determine what the 2011 debt ceiling lessons might be for markets given that as political brinkmanship took Washington to the edge, Euroland break-up fears escalated, with Spanish and Italian borrowing costs rising substantially and there was also the looming threat of a ratings downgrade.
Arguably it was the threat that the peripheral sovereign debt crisis represented to Euroland stability that meant that investors’ appetite for Treasuries largely did not wane even as the potential for a missed (or, more than likely, delayed) payment rose, and it is apparent that suppression of Treasury yields was in large part thanks to investors’ willingness to pay an insurance premium for a safer asset.
In picking through what happened to markets at the time of the last US debt ceiling impasse, the early headlines about a potential downgrade and then indications of little progress as the deadline approached seemed to have kept Treasury yields elevated, failing to rally on days when Italian spreads moved sharply. However, as the deadline approached and fears about a possible missed payment came to a head, Treasuries rallied substantially, with yields pushing to new lows as a risk-off tone dominated. But it is hard to say with any confidence how much of the rally, if any, was debt ceiling related. Equities certainly declined in part due to debt ceiling fears, but the declines were almost certainly compounded by the European situation and it’s worth noting that the Fed introduced date-dependent rate guidance on August 9th, and this looks to have been their most powerful tool in suppressing long-term yields.
This time the overall position of economies and markets as backcloth to the deficit and debt negotiations is substantially different, and in particular gauging what the broader market will do without Euroland problems to the fore is a challenge. For now, and from first principles, it would seem likely that investors may elect to buy longer dated debt securities if and when prices fall in the face of US deficit and debt-related angst, given the greater vulnerability of risk assets to any especially ugly negotiations on shifting the debt ceiling.
From a purely technical and operational perspective, the US Treasury can roll over the securities that mature at the end of October even without an increase in the debt ceiling, but it would require that they prioritize payments in order to avoid delaying any payments on the debt. While this is an operational possibility, it seems that there is limited capacity to fine tune any prioritization of payments. As we understand it, there are three main systems – the Department of Defence Disbursing Offices, the Bureau of the Fiscal Service (which deals with Treasury security related payments) and the Financial Management Service (which makes all other payments) and currently the way that they are set up, is that either all payments are made or none at all. There is a clear unwillingness to prioritize payments given that determining what the pecking order might be is politically messy, but if push comes to shove, and Congress cannot strike a deal in time, the ability to pick and choose who gets paid does exist, if only on a broad basis. In 2011, the press reported that there was some contingency planning going on, but the details of those plans were unknown.
To give a sense of what might be at risk, we note that payments from last year on the date corresponding to our projected deadline were $112.6bn, with much of that concentrated in the $99bn in bills (this year, the maturing bills will be $93bn).
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
