The Big Idea

Tick tock toward the debt ceiling showdown

| April 21, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Investors have started hedging the risk of a contentious debt ceiling showdown later this year even though the risk of US default looks low. Credit default swaps have started pricing as if this showdown will be among the most contentious in recent memory. And the Treasury bill and agency debt markets show investors paying a high price to avoid exposure to the Red Zone, when potential default could happen. The most likely outcome will send the negotiations right down to the wire before the ceiling is lifted. The current risk premium on Treasury debt maturing in the Red Zone consequently looks attractive.

The US hit its current $31.4 trillion debt limit on January 19 this year, and the Congressional Budget Office soon after estimated the US would run out of money for federal obligations sometime in July or August. The exact date depends on the size and timing of revenues and expenses, especially April 18 federal income tax receipts and June 15 estimated corporate tax receipts. Based on recent tax receipts, some analysts have estimated that the Red Zone starts in June.

The widest 1-year US CDS of recent debt showdowns

Although the possibility of a showdown was clear as early as the first week of January, the market has become progressively more nervous. One-year credit default swaps on US debt in the last week reached 107 bp, exceeding every previously contested increase to the debt ceiling in the last 15 years (Exhibit 1). Even in the debt ceiling showdown of 2011, resolved only two days before Treasury expected to run out of money, 1-year credit default swaps on US debt only reached 80 bp.

Exhibit 1: Pricing on US CDS now exceeds the peak of earlier showdowns

Source: Bloomberg, CME, Santander US Capital Markets

Distortions in the OIS basis and T-bills

Concern about potential default has also distorted pricing in the Treasury bill market. The newest 1-month Treasury bill—debt that matures well ahead of the Red Zone—now trades with a mid-market yield an extraordinary 173 bp below current 1-month term SOFR or OIS. The yield difference between generic 1- and 3-month bills also shows the difference between debt maturing ahead of rather than in the Red Zone. In recent weeks, 1-month yields have dropped while 3-month yields have gone up to create the current 142 bp difference (Exhibit 2).

Exhibit 2: 1-mo T-bills now yield 142 bp less than 3-mo T-bills so investors can avoid maturities in the late-June-to-late August potential default window

Source: Bloomberg, Santander US Capital Markets

Distortions in the agency debt basis

Concern about Treasury debt maturing in the Red Zone has also left vulnerable issues trading at higher yields than FHLBank discount notes. For example, 3-month Treasury bills have traded recently nearly 5.10% while 3-month agency discount notes have traded below 4.90% (Exhibit 3). Even though a default of Treasury debt would almost certainly affect the credit of the FHLBanks, the debt ceiling would not technically impede the FHLBanks’ ability to issue debt needed to meet principal or interest payments. Of course, a US default could also freeze markets, leaving the FHLBanks unable to issue. For now, apparently, the market discounts that possibility.

Exhibit 3: Treasury debt now trades at higher yields than agency discount notes

Source: Bloomberg, Santander US Capital Markets

The heightened concern in the markets reflects the political risks in lifting the debt ceiling. And although the Biden administration and House Republications have both expressed their determination to lift the ceiling and avoid default, there is little practical progress.

Base case: down to the wire, or just past it

Because of the lack of progress on legislation to lift the debt ceiling, the base case looks like it will go right down to the wire. Treasury Secretary Yellen and others have outlined the immediate damage an actual default would do to the financial system and the economy worldwide, and to the US cost of funds and role in the financial system in the long run. Presumably as the market reprices toward those possible outcomes, policymakers will resolve their differences and authorize the debt needed to pay US obligations.

If policymakers did not raise the debt ceiling in time, it seems highly likely the financial stress of a US default would quickly bring about resolution. If the delay between default and resolution is short enough, the damage could be limited. For holders of Treasury debt in particular, the damage could be small in part due to Treasury and Fed action.

The Treasury and Fed in the past have considered their response if the government does run out of money and the Treasury finds itself unable to pay principal or interest. Their thinking is described in most detail in the minutes of an FOMC conference call on October 16, 2013. Two items worth highlighting in particular:

  • The Treasury and Fed would likely act to cushion the impact of default until Treasury could raise new funds by keeping track of principal and interest due and rolling it ahead in 1-day increments

“…if the Treasury decided not to prioritize principal and interest payments and had insufficient balances to redeem maturing securities, it would instruct the Reserve Banks to roll forward in one-day increments the maturity date of maturing securities. The securities would then continue to be transferable on the Fedwire® Securities system. Interest payments would also be held within the system until the Treasury authorized their release. When the Treasury could make its payments, it would pay principal and interest in a manner that market participants have indicated would be the least disruptive to their operations. (p. 9)”

  • The Fed would likely prevent a catastrophic increase in bank capital or liquidity requirements that might trigger a fire sale of Treasury or agency debt

“…the supervisory and regulatory treatment of Treasury securities, other securities issued or guaranteed by the U.S. government or its agencies, and U.S. GSEs, for which a payment has been missed—these will not have any change in their risk-based capital treatment. Their risk weights don’t change. They will not be adversely classified or criticized by examiners, and their treatment under other regulations, such as Regulation W, would not be affected. (p. 12)”

Even though any delay in cash flows due would represent a present value loss, the actions of Treasury and Fed would likely protect ultimate investor receipt of principal and interest.

One further implication: liquidity

One other thing for investors to keep in mind is that the Treasury can hit the debt ceiling and keep meeting federal obligations through well-known extraordinary measures—but eventually it has to replenish its coffers. At the end of almost every negotiation over the debt ceiling, whether contentious or not, the Treasury ultimately has issued a surge of debt to restock its supply of cash. In 2011, that created a 1-day $124 billion surge in publicly held debt, in 2013 a $187 billion surge, in 2015 a $199 billion surge and so on (Exhibit 4). At the end of the current episode, investors should anticipate another surge that would likely pull cash from one or both of the other two major storehouses of financial market liquidity—bank balance sheets or the repo market. Banks should be prepared, and so should repo participants.

Exhibit 4: Debt showdowns usually end with a surge in Treasury issuance to replenish federal coffers

Source: US Treasury, Santander US Capital Markets

* * *

The view in rates

OIS forward rates price in one more Fed hike in May and cuts of 50 bp through December. The market has moved closer to the Fed’s own projected path in the last few weeks. But the market is clearly assigning more weight to the possibility that tighter bank credit will magnify the impact of cumulative Fed hikes and drive cuts later this year.

Fed RRP balances closed in the last few days at $2.29 trillion, up $37 billion from a week ago. Money market funds continue to get net inflows, and that is flowing into RRP.

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Settings on 3-month LIBOR have closed Friday at 525 bp, down 1 bp from a week ago. Setting on 3-month term SOFR closed Friday at 507 bp, up 9 bp from a week ago.

Further out the curve, the 2-year note closed Friday at 4.18%, up 8 bp over the last week. The 10-year note closed at 3.57%, up 6 bp over the last week.

The Treasury yield curve has finished its most recent session with 2s10s at -61, flatter by 3 bp. The 5s30s finished the most recent session at 11 bp, 2 bp flatter on the week.

Breakeven 10-year inflation finished the week at 229 bp, down 1 bp in the last week. The 10-year real rate finished the week at 129 bp, up 8 bp in the last week.

The view in spreads

Volatility has continued returning to earth after the MOVE index rocketed to levels last seen in 2008 and 2009. That should keep helping risk assets, credit especially. MBS is weighed down by the liquidation of $114 billion in securities formerly held by Silicon Valley Bank and Signature Bank. The Bloomberg investment grade cash corporate bond index OAS has held over the last week at 157 bp. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields closed Friday at 163 bp, wider by 1 bp from two weeks ago. Par 30-year MBS TOAS has closed Friday at 56 bp, tighter by 6 bp on the week.

Investors short volatility should note that the Treasury market has started to reflect concerns about a debt ceiling showdown in late July and early August.. Volatility should rise if the standoff goes down to the wire.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market are funded with floating debt. Leveraged and middle market balance sheets are vulnerable, especially with the sharp tightening of bank credit in the wake of SVB. Commercial office real estate looks weak along with its mortgage debt. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. Some commercial real estate funded with floating-rate mortgages have started to show some stress, too.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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