The Fed and Treasury have seen enough debt ceilings to develop a playbook that can be pieced together from past FOMC transcripts and Congressional subpoenas. The Fed does not want to interfere in debt ceiling negotiations, which are part of the political process. But a default by Treasury may trigger enough market turmoil to affect financial stability and ultimately prompt Fed action. At the moment, Treasury debt maturing around late October is already exhibiting some signs of distortion. Treasury will make noises to scare Congress into action, but it understands the importance of avoiding default and will prioritize debt payments once it runs out of headroom. Prioritization can support the Treasury market indefinitely, and even if that support is withdrawn the Fed stands ready to act as dealer of last resort. In this post we detail the debt ceiling playbook as the ceiling moves from not binding to binding, and review the nuclear option in case things still don’t work out.
Debt Ceiling Not Binding: Issuance Prioritization
Treasury has been preparing for the debt ceiling by paying down Treasury bills to increase headroom under the limit. Treasury issues debt under a “regular and predictable” framework, which in practice means maintaining a predictable coupon issuance schedule and meeting cashflow fluctuations by adjusting bill issuance. [Coupons are longer dated Treasury securities (2 to 30 years), while bills are shorter dated (<1 year)]. For example, the emergency pandemic spending last March was financed with a $2t surge in bill issuance. In the same way, headroom under the debt ceiling is created by cutting bill issuance. Note that this in turn reduces the investment options of bill investors and leads them to invest in the RRP, whose balances have been steadily rising. The Fed has prepared for this deluge by raising the RRP counterparty limit from $80b to $160b in September.
The market has also been preparing for the debt ceiling by rotating out of Treasury securities that mature around the October 18 drop-dead date. Major investors like the $4.5t money market fund industry face restrictions in holding defaulted securities, so out of caution they are avoiding at-risk Treasuries. This creates a “kink” in the bill curve where at-risk bills trade at lower prices (higher yields) than those that mature further from October 18. However, the kink is only 5bps while it was as high as 50bps back in 2013. Recent bill auctions have also been well behaved, suggesting that investors are so far largely unworried.
Debt Ceiling Binding: Payment Prioritization
When Treasury reaches the ceiling limit and also runs out of accounting tricks, then it will not have enough money to meet all its obligations. But it will still have enough money to meet some of the obligations. Prior Administrations have claimed technical impossibility or illegality in prioritizing payments, but that was largely to exert political pressure on Congress . A 2016 Congressional report (h/t @AnalystDC) reveals the Obama Administration was working with the NY Fed to prioritize debt payments and social security payments during the 2013 debt ceiling episode. This is essentially a compromise that maintains pressure on Congress while limiting the potentially significant financial and humanitarian costs. The same policy choice will very likely be made this time around.
Cashflows from prior years suggest that Treasury can easily meet debt payments indefinitely under a prioritization framework. Note that maturing debt principal is assumed to be rolled over, so only interest payments must be paid out of cash inflows. Once debt payment prioritization is announced then default risk disappears and the Treasury market, including auctions, should immediately resume normal functioning. Cash inflows over the fourth calendar quarter are usually steady, with data from the prior 5 years showing around $850b in cumulative inflows. These inflows are primarily from tax receipts, with a smattering from other inflows like military equipment sales and Federal Reserve “earnings.”
Social security and debt interest payments outflows over Q4 have also been fairly steady the prior 5 years. Assuming this trend holds, the amount of cash inflows will greatly exceed the prioritized payment outflows. The biggest losers of prioritization are those who usually receive large government expenditures: the medical and defense industry. Both of which are well funded industries that can handle a liquidity squeeze (and send lobbyists to hasten Congressional action).
Nuclear Option: Dealer of Last Resort
In the very, very unlikely event that the debt ceiling is unresolved and prioritization is discontinued, then the Fed comes to bat. Treasuries are a form of money in the financial system, and their ‘moneyness’ will be protected at all costs. A default opens the door to great uncertainty – how will market participants handle defaulted Treasuries?
The biggest disruption in the event of default would probably be in the plumbing of the financial system. Repo lenders, who are primarily money market funds, may be unable or unwilling to accept defaulted Treasuries as collateral. Repo is a multi-trillion market where investors pledge securities as collateral for short-term loans. This implies a potentially significant and sudden loss of financing for leveraged investors. Many other investors may also be unable to hold defaulted Treasuries under their investment mandate. The emergence of default risk will likely result in a volatile shift out of at-risk Treasuries into other Treasuries (or RRP). Treasury data indicates there are over $8t in Treasuries scheduled to receive principal or interest payments in Q4, so there is potential for significant disruption.
The Fed has the tools and motivation to backstop any Treasury market dislocation. When the Treasury market liquidity disappeared last March, the Fed cranked up the printers and bought $1 trillion of Treasuries over just 3 weeks. In the same way, FOMC transcripts show the Fed is prepared to 1) provide liquidity against defaulted Treasuries in its repo operations, 2) offer to swap out defaulted Treasuries for “clean” Treasuries with its securities lending program, and 3) and fire up the printers to purchase defaulted Treasuries outright. At the end of the day the Treasury market will be strongly supported as it was last March. The Fed will be the Treasury dealer of last resort.