About That Debt Ceiling Crisis…

With just one month left until the “X Date”, better known as the first day on which Treasury has exhausted its borrowing authority and no longer has sufficient funds to pay all of its bills in full and on time, and also known as the date the US is technically in default on its debt obligations and would be forced to prioritize debt payments according to that infamous 2011 Fed transcript…

… traders were hoping if not for resolution, then at least a modest dose of optimism in the days ahead: after all with Houston reeling, the last thing the US needs is a full government shutdown in addition to the emergency crisis in Texas.

Alas, that’s precisely the opposite of what is taking place in the market, where the September/October Bill Spread has again blown out to record levels…

… making the October T-Bill “hump” the worst it has been yet.

One potential catalyst for the spike in odds of an adverse outcome is that earlier today, the chairman of the conservative House Freedom Caucus said aid for victims of Hurricane Harvey should not be part of a vehicle to raise the debt ceiling.

Quoted by The Hill, Rep. Mark Meadows (R-N.C.), a Trump ally who leads the conservative caucus, said disaster aid should pass on its own, apart from separate measures the government must pick up in September to raise the nation’s borrowing limit and fund the government.

“The Harvey relief would pass on its own, and to use that as a vehicle to get people to vote for a debt ceiling is not appropriate,” he said an interview with The Washington Post, signaling agreement with Trump on the approach. It would “send the wrong message” to add $15 to $20 billion of spending while increasing the debt ceiling, Meadows added.

Ironically, it was precisely the Harvey disaster that prompted Goldman yesterday to lower its odds of a debt ceiling crisis from 50% to 33%, on the assumption that it would make conseratives more agreeable to a compromise, when in fact precisely the opposite appears to have happened, and the new dynamic is now playing out in the market where the odds of a government shutdown have never been greater.

So what does it mean for the US if the T-Bill market is correct and a debt ceiling deal is not reached in time over the next 30 or so days? For an unpleasant perspective on what may happen next, here is Deutsche Bank’s preview of what a debt ceiling crisis would look like:

Guide to a Debt Ceiling Crisis

If Congress doesn’t act in time and the above fallbacks are deemed untenable, the Treasuries with affected principal or coupon payments would likely be handled in two ways, according to scenarios considered by SIFMA. The first option would extend maturity and coupon payments, where payment decisions are explicitly announced by Treasury one day at a time, and both coupon and principal payments are ultimately made in full once the debt limit is raised. These securities would be able to be transferred normally, and a market for them would develop. While the security is not “defaulted” as its maturity date has been extended in systems, the extension would likely constitute a change in terms that triggers CDS.

The other outcome would a failure pay , where Treasury does not set a date for future payment, and there is no pre-announcement (or it comes last minute). A failure to pay would mean the affected securities drop off the Fed system and cannot be transferred normally. A market would eventually develop, but once there is a failure to pay and the securities are not extended in systems, they cannot be “unmatured” and maturity extended.

Regardless of whether it is a payment extension or a failure to pay, the longer Treasury remains in default, the worse the situation for financial markets. Market reactions and market functioning might be comparatively stable at first, but the concern is of widespread panic and systemic market disruptions.

As for immediate ramifications, noted that CDS would likely triggered either default scenario , as sovereign CDS is triggered by either a failure to pay, repudiation/moratorium, or a restructuring. A failure to pay occurs when a sovereign doesn’t pay principal or interest when due, with a 3 day grace period applying to that due date in the case of the US. In our view, a CDS trigger would apply to all debt obligations backed by the full faith and credit of the US government (including GNMA, FHA securities, etc.). A CDS event is unlikely to have much direct market impact, however, as net CDS exposure is a modest $1bn as of the end of July, down from about $4bn in 2013 and its peak near $6bn in 2011. As long there is no one particular bank that is overly short protection, we do not expect any knock-on CDS event. 5y CDS is currently suggesting no real concern, sitting at the bottom end of its 19-24bp ytd range. While the supply of deliverable securities is more than adequate to satisfy the outstanding contracts, demand deliverable bonds may cause distortions . The 2.25% Aug 2046 bonds are currently the cheapest-to-deliver into the CDS, and would likely trade upward in price towards recovery value.

Among Treasury market investors, money market funds are a key group possible propagation risk . Even after money fund reform, government funds continue to be quoted at a stable $1 NAV, leaving them vulnerable to perceptions around “breaking the buck,” and therefore large scale investor redemptions in an extreme scenario. Treasuries accounted for $678bn of money funds $2.7tn AUM as of the end of July, while Treasury repo makes up another $595bn (with about $150bn of that made up by RRP’s with the Fed). Money funds’ Treasury holdings tend to be concentrated in securities maturing in the first month – more than 40% of their Treasuries held at the end of July matured in August. This suggests that the bias will be for money funds to accumulate more securities maturing around the debt ceiling, though they may be cautious around specific issues. However, it’s worth noting that they then owned over $40bn combined in the October 5 bills, October 12 bills, and October 15 coupon maturities – more than 20% of the amount  outstanding. Of the $1.3tn of Treasuries (bills and coupons) that mature between October and mid-January, money funds own about 19% – potentially an important factor in the event that a default drags out. Also note that maturing notes and bill holdings are concentrated in a relatively few fund families.

Potential outflows from money funds has implications repo market . Possible forced selling of Treasuries, money funds would likely cut back on their provision of financing to banks through repo. While reforms have reduced banks’ reliance on short term funding and put them in a place to better withstand a significant reduction in availability of things like repo funding, a sharp contraction in overall repo financing would likely have ramifications for market functioning and liquidity.

In terms of market plumbing, given the reliance Treasuries managing credit risk derivatives , a default event could spread quickly to derivatives market via a sudden drop in the valuation of UST collateral. This loss in value would trigger calls for additional collateral, and given the widespread use of UST’s, it is possible that a number of market participants fail to post sufficient collateral; this would constitute a default in a centrally cleared trade. The requirement that the surviving counterparty replace the risk of that trade could subsequently result in a major revaluation of all related trades, triggering new collateral calls, and potentially create a vicious cycle.

How might the Fed might react to a major disruption?

The question is complicated by a possible reinvestment decision in the September meeting, but extracting that for the time being, there is nothing immediately apparent in the Federal Reserve Act that would preclude the Fed from purchasing defaulted Treasury securities. This would likely not be a proactive step, as the Fed would not want to be seen “bailing out” the Treasury, but given the extremity of a default situation, the Fed would be governed by its financial stability mandate.

The Fed could intervene by removing defaulted securities from the market and sell or repo non-defaulted issues to provide the market with good collateral. Additional emergency facilities similar to those seen in 2008 are another option wherein the Fed could support money funds by accepting their assets and providing liquidity. To the extent that liquidity concerns became extreme the Fed could obviously move to add further monetary accommodation especially if it perceived knock on effects to the growth and inflation outlook.