There is considerable market anxiety around the US Treasury missing the so-called X-date, the date when the Treasury would run out of options to pay its obligations, including the repayment of maturing Treasury debt. Given this context, we look at scenarios including that of a potential default and its implications for money market funds, ETFs and the US Fed, among others.
US President Joe Biden and Speaker of the House Kevin McCarthy have reached a tentative agreement on raising the US debt ceiling that now needs the approval of the House and the Senate. There is no question about the US Treasury’s ability and means to repay the debt, but the US Congress cannot allow this due to an arcane rule that requires approval to issue debt beyond a certain amount, currently at US$31.4 trillion (Figure 1).
What will motivate the political leaders to get a deal done? Their constituents will be the primary motivating factor for Speaker McCarthy and President Biden. Each political party wants to get its way, which will result in posturing and being rigid about their respective objectives. However, in the end, neither party would want to take the risk of being held accountable for a Treasury default.
What happens on the X-date, the day the US Treasury runs out of money? The US Treasury Secretary will notify the US Fed that they do not have the money to make due payments. This could include social security payments, medical payments, military spending, debt repayments or other obligations. Those payments are likely to be suspended, but what the market is concerned about is the inability to repay the Treasury debt.
What happens if the Treasury cannot repay maturing debt? The Treasury would notify the Fed a day in advance of the maturity date. The Fed would then change the maturity date of that particular issue to the following day. For example, if a T-Bill were maturing on a Tuesday, the Fed would be notified by the US Treasury on Monday and then the maturity date would be extended to Wednesday. This maturity extension would continue to happen until the debt was repaid. This means, debt owners would get a delayed repayment.
Why would the Fed change the maturity date? This enables the security to remain active on the Fed’s wire and other important settlement systems and to continue to be traded and pledged as collateral in repurchase agreements (repo).
Would the issue still accrue interest and how would the issue be priced? The issue would not accrue interest. In order for the Treasury to be able to pay interest beyond the issue’s maturity date, the Congress would have to legislate an additional payment. Expectations are the issue would be priced at a discount plus an additional “liquidity” premium. Potentially, the issue could price significantly higher in yield compared with other T-Bills of similar maturities to account for any lack of interest and uncertainty surrounding the maturity date.
Could the issue be pledged as collateral? Yes. The Fed has indicated that it would accept the issue as collateral through a repo at its Primary Dealer Financing facility, a permanent facility established after the September 2019 repo market challenge. Primary dealers can go to this facility, borrow cash and pledge US Treasury collaterals at the current fed funds rate of 5.25% (Source: US Fed, as of 29 May 2023). This will be an important facility to maintain order in the repo market.
What about dealer-to-dealer or buy-side-to-dealer repo? The exclusion of the issue would be up to each counterparty. Bi-party repo could be monitored more easily than tri-party repo. Keep in mind it takes a few weeks to update a tri-party repo collateral schedule, which means excluding a specific issue could be difficult and time consuming.
With a standard hair cut of 2% on US Treasury collateral, the fund would get 102 cents in collateral for every 100 cents lent. This is designed to protect the lender in the event the collateral has to be liquidated. However, according to the Securities Industry and Financial Markets Association, Treasuries maturing next day are ineligible for both general collateral financing repos (GCF) and Sponsored GC settlement obligations. Depending on the timing of the delay, this could impact eligibility.
What about Money Market Funds (MMF)? MMF could employ a variety of strategies through this period. An MMF must disclose its holdings and make those publicly available. We encourage everyone to look at these holdings and other supporting documents (fact sheet, prospectus, etc.) before making any investment decisions.
There are three categories of taxable MMF. Prime, government and Treasury funds that can do repos and Treasury funds that cannot do repos. It would be unusual for a prime money market fund to own US Treasury debt. Prime fund strategies tend to generate their returns by investing in credit issued by banks and corporations.
Generally speaking, government and Treasury money market funds that invest in repos hold large balances in repos that mature in a day or a week. They tend to be a better relative value investment versus owning T-Bills. Looking at some of the largest government MMF, we observe repo holdings of over 70% of the fund’s AUM (Crane data, as of 30 April 2023). This could reduce the likelihood of MMF owning Treasuries that mature on the X-date.
Treasury funds that cannot do repo (also referred to as “Treasury only” MMF) could have exposure to a T-Bill that matures on the X-date. These MMFs could opt to hold or sell the issue. They could build liquidity in the fund by holding cash at their custodian. Each MMF could employ a strategy that it deems is best for its investors. Please consult the holdings of the MMF you are interested in.
Will there be enough liquidity in these funds? The US Securities and Exchange Commission (SEC) categorizes all US Treasury debt as liquid, meaning it can be sold during extreme market events. Thus, treasury MMF liquidity levels are 100% according to the SEC’s definition. Some market experts anticipate US Treasury yields would drop if the X-date passes as this would be a “risk-off” environment.
Would the MMF yield decline? If the MMF owned an asset that was not paying interest the fund’s yield would decline by the commensurate amount.
Would this affect the dividend or interest accrual of the fund? No, this method would not change.
Have MMF balances declined because of worries about the debt ceiling? Overall MMF balances are at historically elevated levels. According to Investment Company Institute’s data from May 24, 2023, total MMF AUM is US$5.38 trillion, up 2.3% from a month ago and up 18.9% from a year ago. Government and Treasury MMF AUM is up to US$4.48 trillion, up 2.2% from a month ago and up 11.7% from a year ago. Prime MMF AUM is up to US$789 billion, up 3.0% from a month ago and up 89% from a year ago.
What about ETFs? There are some short-term debt ETFs that could own T-Bills that mature on the X-date. Strategies to manage through this period could be similar to those for an MMF. ETFs are required to disclose their holdings each day. Please consult the holdings of the ETF in which you are interested.
In this environment, what could the Fed do? The Fed wants to remain apolitical and do not want to interfere in the political process. The Fed has not publicly discussed what it might do during this potential period of market stress, but through its charter it is obligated to provide liquidity and reduce volatility in the capital markets during periods of stress.
Based on meeting minutes from the 2011 debt ceiling crisis, we know there was considerable debate among Fed officials on what could have been done had the Treasury crossed the X-date in 2011. The debate and discussion included options to purchase the specific issue (a form of quantitative easing), swapping the specific issue with other holdings in the Fed’s portfolio, engaging in repos and potentially easing the monetary policy rate.
What about the ratings agencies? Fitch has put US Treasury debt on negative watch, citing the debt ceiling debate as inconsistent with a AAA rating. Other rating agencies have indicated that a missed payment would trigger a “selective default” rating. It is unclear how this would influence investor behavior or trigger the requirement to sell. It could also impact other debt that is supported by the US Treasury debt (municipal debt and some foreign obligations).
Would the issue still be eligible as collateral for derivatives trades? The Chicago Mercantile Exchange has indicated it would not exclude the specific issue from eligible collateral. It is not clear if the issue would need to be replaced or if the haircut on the issue would be increased from the standard US Treasury haircut.
Our base case was that politicians in Washington would find common ground to avoid a “default”. The potential political fallout might have been so significant they would not risk it. That being said there is still a legislative process that must be followed under a constrained time line and market risk remains.