The dynamics of the debt ceiling

Peter Maiorano: What we’ve seen transpire over the ebbs and flows of the conversation that they’re having and the press releases you’re seeing, the stresses being most evident in the T-bill market, where you’ve had a tremendous backup or rise in yields on June bills.

Bipan Rai: Good day, everyone, and welcome to another edition of the FX Factor podcast. Of late, markets have been incredibly captivated by what’s been going on with respect to debt ceiling talks in the United States. Of course, the main battle lines are between House Republicans and President Biden over the course of the last month or so. What’s really concerning is the fact that we’re heading closer and closer to the projected ex-date, which is when the US Treasury projects that it will run out of funding for extended government spending. And also, of course, probably a little bit more relevant for markets when we could face potential defaults on Treasury bills and potentially bonds that are coming due in the early part of June. So for today, I thought I’d invite one of our prior guests, Peter Maiorano, who is a Managing Director in the Global Collateral Finance Group, to speak a little bit more about the debt ceiling, including what are the risks that we could see as we head towards the projected ex-date without an agreement and potentially what to look for beyond. Pete, welcome back to the show.

Peter Maiorano: Hey, Bipan. Thank you very much for having me.

Bipan Rai: To start things off, I mean, why don’t we really hash out what’s been going on of late between talks and, of course, day by day things could change. But as it stands now, there is no agreement right now in place between House Republicans and the Democrats. How are you framing things? How are you really game planning from a market perspective at this point?

Peter Maiorano: You know, it’s a difficult situation, right? The politicians, unfortunately don’t care as much about exactly what’s going on in the market as we do as we’re living and breathing it every day. And they seem to feel, you know, very comfortable taking it to the very end. What they are being told and think is the last minute. In fact, even the other day was seeing some comments where congressmen were questioning whether June 1st was even a real, quote unquote, date and they wanted more transparency from Yellen on the math, I guess, of that. So it’s a little troubling, to say the least, that everybody’s willing to go to what they think is the 11th hour, if you will. What we’ve seen transpire over the ebbs and flows of the conversation that they’re having and the press releases you’re seeing, the stresses being most evident in the T-bill market, where you’ve had a tremendous backup or rise in yields on June bills. We had the June 1st bill hit over 7% at one point yesterday. So bills from June 1st out to mid-June, call it June 13th ish, you know, in the 650 to 675 range, later June bills you know, more like 610 or 5 and change on their yields. So real impact in the market place, real cost to Treasury for securities that they’ve auctioned in the one month space under these conditions. So taxpayers bearing the brunt of it. Just an unfortunate situation. It looks like a replay of 2011.

Bipan Rai: And I’m glad you brought up the example of 2011 and our many conversations that we have about what’s been going on in the money markets and of course, what could play out here. You know, we did sort of discuss the playbook from 2011 because, again, there was a Fed meeting then and there has been that sort of transcript from that meeting that’s been recirculated. And one of the things that caught our eye was potentially what the Treasury could do in the event of a potential default. That’s more or less a legislative driven as opposed to anything else. You know, there is this feeling that they could prioritize some payments versus others. I mean, what do you think of that? Do you think that’s a likely plan of attack this time around? If there was, say, a potential for a default due to the legislative process and negotiations right now?

Peter Maiorano: Yeah, Bipan, I do. As you said, you know, we have the transcripts of the 2011 FOMC call. It does look like Treasury would try to prioritize payments and make coupon payments and extend the maturity dates of impacted securities. So, for example, a June 6th bill, a bill that’s supposed to mature on June 6th. On June 5th, Treasury would likely kick out the maturity date to June 7th and so on and kind of go through that day by day. And just in talking to Bank of New York, who’s one of the major custodian banks and one of the larger players in the Triparty repo market, we’ve had calls with them, their systems, everything is in place and capable to be able to handle the situation if it goes down that way, as long as Treasury gives 24 hour notice. So if it was on June 5th and Treasury said that the June 6th bill was now going to be a June 7th bill, the systems are able to handle that. The cusip of that bill stays active in the Fedwire system, that security becomes transferable and eligible in repo sec lending and various other funding type trades. So I do think that’s how it would be handled. The Fed would also accept those securities in their various programs at the discount window and the Fed standing repo facility. And those would be alternative sources of funding for banks that require it.

Bipan Rai: So that’s interesting, actually. And one of the things that I’ve always wondered about is in the case of a selective default, let’s say, how would the Fed use those securities? Would they treat them like non defaulted securities, or would there be another game or route of attack for the Federal Reserve when it came to this?

Peter Maiorano: Yeah, it seems as if they would treat them, you know, there would be no change to the HQLA treatment of those securities or any other change in the way the Fed or the Treasury viewed those securities. So assuming that the maturity really just gets extended out one day and that extension is given, you know, the day before that security was going to mature, then there really shouldn’t be an issue with regard to how the systems and everybody accounts for that. If for any reason, Treasury did not extend the maturity of that security the day before it was to mature, then sort of all bets are off, then there could be an issue. And that according to the Bank of New York, you know, then that cusip goes away, that security doesn’t exist anymore. And basically people would be carrying a receivable on their books, which would not be transferable and would create much larger issues for the market.

Bipan Rai: So let’s talk about the comparison to 2011 again, because I think it’s quite noteworthy that there are a couple of facilities in place at the Federal Reserve now to potentially handle some of the concerns that they had back in 2011, one of which is the fact that repo rates did spike in 2011 leading to that ex-date. I mean, can you talk a little bit about why the Fed might not be as concerned this time around with respect to that risk?

Peter Maiorano: Yeah, and sort of not to say that the Fed’s not concerned. I mean, I think everybody seemingly accepts some folks in Washington, D.C. unfortunately are concerned about you know, you’re talking about an event that, well, people prepare for it, test their systems to be able to handle how they think securities will be treated and how they think things will be handled. We’re still talking about an event that has frankly never happened before and hopefully never does happen. So could there be downstream effects that are unintended or on, you know, not exactly planned for? You know, you never know, right? In a situation like this, we’re all trying to get ready for something that hopefully will not happen and has never happened before. But, you know, if it does, everybody’s trying to be as ready as they can be. So just going back to, you know, the Fed and having these programs in place, you know, such as the standing repo facility, for example, or other programs that are more recent, I definitely do think it gives the market a little bit of faith or hope that at least things won’t get too out of control with regard to, you know, if there were a spike in funding, you know, that there are mechanisms in place to try to deal with that and not have the situation be rampant or run out of control. But, you know, you look at the bill market, right? I mean, you basically have, when you eliminate the major buyers of T-bills in general or money market funds, who cannot own a security that’s in default, right? So you’re talking about one of the largest players in the bill market now being absent and not able to even step in and buy. So despite the fact that funding and repo, you know, may not spike too dramatically if and when the Treasury were to default, you still have these ramifications rippling through, you know, the bill market and other markets, right?

Bipan Rai: That’s a very good answer, Pete. And, you know, one of the things that I’d be remiss if I didn’t mention was, you know, the dynamics at play in 2011 where we did see a lot of investors, particularly the money market space, prioritize liquidity. You know, as a result of that, there’s a greater degree of movement from money market funds into, say, deposits at commercial banks. That’s quite relevant given what we’ve seen over the past couple of months. My question to you, do you expect something similar this time around, given the fact also we should consider that if we look at where market rates are now relative to where they were in 2011 and also the dichotomy of where market rates are right now compared to say, you know what bank deposits are yielding. I mean, will we see the same degree of prioritization of liquidity and cash this time around?

Peter Maiorano: Yeah, that’s a great point, right? I think there are a couple of key factors there. One, today, you know, the money market funds, one of the things that they’re doing to prepare themselves for this to a large extent is they are amending their collateral eligibility schedules to eliminate securities, US treasuries that mature in a day. So I think that is giving them a great deal of comfort that at least they know that no security that is maturing the next day would be put into a triparty agreement that they’ve got in place with the bank. Now, just to circle back to the example I gave before, if you have a June 6th bill that’s impacted, and on June 5th, the Treasury comes in and says that June 6th bill is now going to be pushed out to June 7th, that means that on June 5th, I can still put that bill into a triparty agreement and fund it with a money market fund. And presumably each day the Treasury keeps kicking that maturity out. That will continue to allow us to fund that bill with money market funds in their triparties. But the money market funds do feel protected, if you will, in that they will never end up with a bill or security that’s matured and was not paid out by Treasury in a triparty. So I think from their perspective, in conversations that I’ve had with folks on that side, they are not looking at this as an issue where they would have to pull money that they have in repo away from banks. It’s an issue specific meaning cusip specific problem, and they feel that they’ve dealt with that sufficiently by amending their collateral schedules. So I don’t anticipate the money market fund complex, if you will, who provides a lot of funding to the repo market. I don’t foresee them pulling away from banks in triparty and therefore, you know, I really don’t see a huge drain on liquidity. Now, if there are people, either investors who are putting their cash in money market funds, if they, for whatever reason, pull their money out, then money market funds will have, you know, less cash to put into the repo market in general. And that’s sort of a different animal. That, coupled with the fact that we have still 2.1 close to 2.2 trillion in the Fed’s reverse repo facility, which is mostly money market fund cash, you know, somewhat optimistic that there’s sufficient liquidity in the system to prevent a repo spike from occurring. Anything of any significant magnitude.

Bipan Rai: I’m glad you brought up the overnight reverse repo rate facility, Pete, because again, that is a noted difference from 2011 in the sense that the Fed now has this facility well established and well entrenched and of course, take up is well north of 2 trillion. Now, you know, given the fact that we didn’t have this facility in 2011 and, you know, we know that, you know, a lot of investors are going to prioritize having liquidity and cash is it reasonable to say that we’ll see increased in additional take up of this facility at money market funds in your view?

Peter Maiorano: So I think that if cash is coming into the money market fund complex, I think that you could see an uptake in the RRP to the extent that banks, you know, don’t have a need for the extra cash that’s coming into the money market funds. And I also don’t think and we’ve talked about this a little bit on past episodes, you know, the size of the RRP, you know, what’s going to make it come down or when’s it going to come down? You know, I don’t think the Fed sees the size of the RRP or the amount of cash that’s in there as a problem where sometimes people in the market have. So I think they see it like, you know, functioning and working, providing its intended purpose. But I wouldn’t you know, I would not be surprised to see an uptake there. If you take the cash that money market funds would be putting into short term bills and all of it probably cannot find a home in the repo market. I would not be surprised at all to see, you know, a bit of an uptake in that RRP. But the other side of that is if and when we do get the debt ceiling passed, the interesting issue is going to be that you’re going to see a tremendous amount of T-bill issuance from Treasury. And in that scenario, I would look to see the possibility of the RRP actually coming down as money market funds, you know, buy Treasury bills, which will presumably be kind of, you know, somewhat cheap given the amount that’s going to be issued.

Bipan Rai: And again, I’m glad you brought that up because, I mean, let’s move forward. let’s say we’re in a spot now where we do have an agreement and the agreement is passed through Congress, both of which, again, are going to be important steps. I don’t think you can say definitively that once an agreement is in place that everything’s gone back to normal. But let’s say we’re past both of those things. And as you said, you know, the Treasury needs to issue more. Can you walk the audience through why the Treasury will have to issue more bills at a rapid pace?

Peter Maiorano: Yeah, well, because of the debt ceiling issue that’s been hanging over their head now for quite a while. Their TGA or effectively the Treasury’s checking account, if you will, balances have gotten exceedingly low. Presumably by June 1st they’ll be down to zero. And they’ve got, you know, outstanding, you know, liabilities that they have to pay for, right? So they you know, I think the estimate that I’ve seen is, you know, anywhere upwards of $1 trillion worth of issuance that would have to come out, that Treasury would have to issue within some period of time from the moment that the debt ceiling is lifted.

Bipan Rai: That’s a lot of liquidity potentially being drained from the financial system if the Treasury does have to issue that much in a short window. And I’ll just say from a foreign exchange perspective, from a broader market perspective in general, that’s one of the reasons why we’re becoming a little bit more circumspect with the bearish dollar view in the sense that, you know, if you do see an incredible amount of issuance to replenish TGA balances, as Pete mentioned, you know, that drain on liquidity does tend to be inversely correlated to the dollar, which means, of course, that the dollar could be stronger in that environment. So that’s one of the things that we are going to be watching for. But equally notable is in terms of who is mopping up those T-bill issuances. If that money is being drained from the overnight reverse repo facility or the funds that are being deposited there, that’s a very different story for the dollar than, say, if households are liquidating their deposits to mop up that issuance. So that’s one of the things that we’re going to be monitoring once we’re on the other side of the Rubicon. And we’re really looking at how markets are treating the issue of the debt ceiling once things are done and dusted. But again, I should touch on things from a cross currency perspective as well. In terms of the basis we have seen demand for dollar hedges increase. That’s been the story since mid-April. And one place we’re not seeing it so much is in terms of spot. That was the case up until this week. We have seen a pronounced bid in the US dollar, which again leads me to believe that the performance in the FX market right now is being driven by that demand for increased dollar hedges, the demand for liquidity and cash, as Pete mentioned earlier. And again, that’s something that we think is probably going to play out over the next couple of weeks. But the view here is that there could be some potential staying power with respect to dollar strength given the liquidity angle once we’re past the negotiation and agreement phase and potentially looking at how things look from there. With that, Pete, I think we’ll wrap up today. Any concluding thoughts? Anything you want to add further before we wrap things up here?

Peter Maiorano: No, not really. Thanks very much, Bipan, for having me. It’s always great to chat with you. And, you know, hopefully the folks in Washington can get their act together a little. It looks like they may go home for the long holiday weekend without an agreement. And let’s not let it spoil our barbecue plans.

Bipan Rai: Absolutely. Thanks, Pete. We’ll definitely have you back on hopefully sooner rather than later to hash out what to expect next. Cheers.

Peter Maiorano: Thanks, Bipan.

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