The Debt Ceiling showdown is upon us once again. There have been several heated battles in the past, the worse being in November, 1995 and July, 2011. Currently, there are estimates that we’ll hit the Debt Ceiling anywhere between mid-February to early March, however, it’s my experience that the Treasury can juggle internal government accounts to delay the debt issuance cutoff.
Though a “default” on U.S. Treasurys is highly unlikely, in the past, there was fear in the market of a “technical default,” where some Treasurys missed coupon payments and maturing securities were not paid. As we approach the Ceiling, these fears will build into the markets, and market participants must prepare for the impact of the Debt Ceiling on the Treasury and Repo markets in advance.
Here’s a look at Debt Ceiling crises in the past:
Though this is a little before my time, James Baker, the Secretary of the Treasury under Ronald Reagan, faced a Debt Ceiling face-off between the President and Congress. Before the Debt Ceiling was breached, he shifted money out of the Social Security trust fund and continued paying the government’s bills. A compromise was eventually reached.
Before July, 2011, the Debt Ceiling crisis in 1995 was the biggest show-down between the Clinton Administration and the Republican Congress. The first effects on markets were felt on Nov 1, 1995, when the details of quarterly refunding were announced, but there was no WI trading allowed. Congress had passed a Continuing Resolution to keep the government funded, which expired on November 13. With the quarterly refunding scheduled to settle on November 15, there was no way to settle the new debt without a higher Debt Ceiling. Throughout the first two weeks of November, as the market waiting for the Debt Ceiling to be raised, the auctions of 3 month bills, 6 month bills, Cash Management Bills (CMBs), 10 year notes and 30 year bonds were postponed.
The auction delays were just the beginning of the problems. The Treasury also owed $25 billion in interest payments and $33 billion in principal maturing on November 15. This obviously caused a lot of concern for the owners of those securities, but in the Repo market there were also concerns with the financing of those securities.
The discussions in the Repo market centered around the specific Treasury securities scheduled to pay a coupon, while there was no increase in the Debt Ceiling. There were questions as to whether Repo counter parties with missed coupon payments were required to pay that coupon to other Repo counter parties. So if the Treasury did not pay its coupon, would a Repo seller still owe the coupon to a Reverse-Repo buyer? The actual coupon payment by the Treasury is governed by the obligations of the bond, whereas the delivery of coupon payments between Repo counterparties is governed by the Master Repurchase Agreement. In 1995, market determined that coupons must still be paid between Repo market participants, even if actual security owner did not receive the coupon payment date from the Treasury.
During that period, overnight Repo rates experienced a lot of volatility, there were several sell-offs due to panics and fears of insufficient cash in the market. Overnight trading was occasionally spotty, and there was no clear market trading pattern.
Some of the funding pressure fear also rested on the assumption that if the auctions were delayed, then once a compromise was reached, there would be immediate Treasury auctions and large new issues settling quickly thereafter. Repo market participants expected upward pressure on overnight rates while the new supply would be digested by the market over a short period of time.
Had a compromise not been reached before November 15, it was expected the Treasury would auction and settle some of the new issues, but not all, taking the Treasury close to the borrowing limit, but not over. Had this occurred, the new issues settling would become the on-the-run’s, as usual, but for sectors which did not have an auction, the outstanding issues would still be “current,” at least until there was a new auction.
Temporary Solution At Hand
Before the Debt Ceiling of $4.9 trillion was breached, Robert Rubin, the Treasury Secretary under President Clinton, was able to shift $61.3 billion in two government employee trust funds out of U.S. Treasury holdings and into cash to free up the limit. This move postponed Debt Ceiling cliff for about three months into January 1996. Then again in January, with the debt debate still raging, Rubin was publicly considering shifting $82.6 billion out of Federal Financing Bank and selling their Treasury debt to various government trust funds in exchange for Treasurys, which would then allow the Treasury to issue more Treasury debt. Naturally, Rubin’s maneuvers did not sit well with Congress, though a compromise was eventually reached.
In June, 2002, the announcement of the 2 year note auction was delayed pending the increase in the Debt Ceiling. The Ceiling was raised soon thereafter and there were no market disruptions.
In October, 2004, the market began to worry the Debt Ceiling limit would be hit in November. The limit was increased with no market disruptions.
Next came the Debt Ceiling crisis in July, 2011, which was, by far, the most disruptive to the markets. Once again, much of the anxiety in the Repo market centered on holding “technically defaulted” securities which were scheduled to mature or pay coupons. Though there were relatively few bills, notes and bonds in August which were affected, those fears spilled over into a general anxiety throughout the whole Repo market. Treasury securities scheduled to pay a coupon or mature, including bills and CMBs all began trading at a discount in both the outright and Repo markets.
This time around, money funds were more aware of the situation and became especially concerned about “technically defaulted” collateral, and with rates so close to zero, there was minimal cost holding cash out of the market. The money funds worried about their overnight cash investments with the dealer community of deliverable and tri-party Repo trades. If a dealer gave the fund a security maturing or paying a coupon the following day and the Debt Ceiling was not raised, that money fund might not be paid the value of those securities. They would be forced to carry a “money wire” fail from the U.S. Treasury on their books until the Ceiling was passed.
Anxiety In The Repo Market
The fears of overnight money fails spilled over into the term Repo markets. Term general collateral (GC) buyers were worried about receiving collateral paying coupons or maturing in August. Term GC markets began trading on the brokers’ screens with a notation, No Intervening Coupon (NIC). Some smart Repo traders financed August paying securities with “no right of substitution.” Some term GC Repo buyers tried to get out of trades and asked for substitute collateral instead of the August paying securities.
Overnight Rates React
Throughout most of July, just coming off the end of the QE3 program, overnight GC Repo rates were trading near zero. However, as the Debt Ceiling approached at the end of July, there was a spike and increased volatility in overnight Treasury collateral rates. Investors began pulling cash from the Repo market, pushing rates higher, and demonstrating that their confidence in the Treasury market had eroded.
Just when overnight rates hit their peak, trading as high as .40% on August 1, the Senate ratified the Debt Ceiling compromise the next day on August 2. Though most of the market was already funded that morning, GC Repo rates dropped considerably that afternoon as cash poured back into the Repo market. The yield on 1 month T-bills dropped from .19% to .03%. During the whole time, the fed funds market only moved from .18% down to .16%, showing how market anxiety was Treasury market specific, and not related to all overnight rates.
Over the next few days, GC Repo rates moved into a morning range between .10% and 0%, though some cash investors just left their excess cash at their clearing banks. With rates so close to 0%, once their cash was not invested in Repo, there was very little opportunity cost of receiving no interest, compared to just a few basis points being paid in Repo. Soon after, The Bank of New York Mellon (BNYM) announced a holding fee on large deposits of idle cash sitting at their client’s clearing accounts. Zero rates are one thing, but fees on top of no interest are another. Cash flowed back into the Repo market and rates returned to relatively normal.
As the Debt Ceiling approaches in February or March, there is a strong possibility of a Treasury and Repo market disruption. Given how the markets can react, even if there is no “technical default” and a compromise is reached, the process preceding can be volatile for some market participants. Note to Repo traders and leveraged outright traders, lend your end of February and March paying securities early and term!