The Big Idea
The knowns and unknowns of crossing the X-date
Steven Abrahams | May 12, 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.
The US in past debt ceiling showdowns has never crossed the date where the Treasury runs out of enough money to meet all federal obligations, so most analysis assumes the same this time. That leaves the market after an X-date unexplored although not unimagined. The Treasury and Fed have led exercises since 2011 imagining markets after an X-date. So, a lot of things are known, but most are unknown. Markets nevertheless have started to prepare. The most obvious hedge: getting ready for volatility across a wide range of markets.
The biggest knowns and the biggest unknowns
Of the short list of knowns after an X-date, a few rise to the top:
- Paying Treasury coupon and principal. Treasury and Fed along with SIFMA have clear rules in place for handling even delayed Treasury coupon and principal and buffering the markets for Treasury repo and trading
- Protecting banks. The Fed has laid out guidance to protect bank balance sheets from forced sale of Treasury or agency obligations and from pressure on capital ratios
- Fed firepower. The Fed has anticipated a wide range of actions it could take to keep policy rates on target and protect market functioning
But on the long list of unknowns after an X-date, a few pose the biggest risk to Treasury and Fed best laid plans:
- A shortfall in cash. A potential mismatch between tax revenues and scheduled Treasury coupons could lead to payment delays even if the Treasury made debt service its top priority
- Failed Treasury auctions. The risk of Treasury auctions that failed to generate all targeted proceeds could lead to delays in paying principal
- Flight from affected securities. The willingness of repo providers and money market funds to take exposure to affected securities even if the Fed or tri-party repo deems them eligible collateral
- Rating agency actions. The response of rating agencies to crossing the X-date, to delays in coupon or principal payments or to a missed payment
- The direction of rates. The response in rates market to conflicting forces: a buyers strike or forced selling in some issues that tries to drive yields higher while concern about Fed action and fiscal contraction under a debt ceiling drive yields lower
Years of imagining an X-date
The Treasury and Fed have discussed crossing an X-date since at least 2011, but some of the first details surfaced in the minutes of a Fed meeting on October 16, 2013. The federal government had shut down, and a new X-date approached. Current Fed Chair Powell was in the meeting, as was current Treasury Secretary Yellen. Then-Chair Ben Bernanke noted that “the minutes of this discussion might be a potentially useful way to communicate some of our thinking to the markets in preparation for another episode.” Thank you, Chair Bernanke.
SIFMA has prepared a primer and playbook for handling Treasury payments ahead of most debt ceiling showdowns in the last decade, and the Treasury Market Practices Group, which advises Treasury, has also weighed in. Some private market participants, such as Bloomberg’s fixed income indices, have laid out plans for an X-date. But most have been silent.
From these sources comes a list of knowns and unknowns. It is worth noting that despite healthy legal and political debate about whether the Treasury can prioritize or make payments to debt ahead of other obligations—Social Security, Medicare, the military, veterans, contractors and so on—the list makes reasonably clear that the difference between prioritizing or not may be small in the long run.
The knowns after an X-date
A list of the knowns after crossing an X-date, based on public documents:
- Paying Treasury interest: Treasury plans to pay interest out of available cash in the Treasury general account. Even if Treasury prioritizes, a mismatch between tax revenues and scheduled coupon could result in a shortfall. If Treasury does not have sufficient cash to pay the full coupon, it can decide by 7:30a ET on the payment date to delay. Interest on delayed coupons does not accrue, although Treasury may announce a compensation rate if Congress explicitly authorizes it. The delayed coupon, when paid, goes to the holder of record at the close of business the day before the original payment date (FOMC minutes 10/16/23SIFMA 12/21, TMPG 12/21)
- Paying Treasury principal: Treasury pays principal out of available cash in the Treasury general account, including proceeds of newly issued debt to stay under the debt limit. If Treasury does not have sufficient cash, it has until 10p ET to roll the security maturity date one day forward to an operational maturity date. If it misses the deadline, it has until 7:30a ET on the original maturity date to delay payment, but the maturity date cannot be extended. Interest on delayed principal does not accrue, although Treasury may announce a compensation rate if Congress explicitly authorizes it. The delayed principal, when paid, goes to the holder of record at the close of business the day before the operational maturity date (FOMC 10/16/13, SIFMA 12/21, TMPG 12/21)
- Eligibility for tri-party repo: a security with delayed interest or with delayed principal and a maturity date rolled forward stays in the Fedwire system and remains eligible collateral. A security with principal that goes unpaid without an extension of the maturity date is not eligible (SIFMA 12/21)
- Ability to trade: securities with extended maturity dates, even if Treasury delays coupon or principal, remain normally tradeable and transferrable (SIFMA 12/21)
- Pricing: pricing services continue to quote affected Treasury securities (SIFMA 12/21)
- Bank risk-based capital: treatment of Treasury debt or other securities issued or guaranteed by the US or its agencies or GSEs will not change. They will not be adversely classified or criticized by examiners, and their treatment under Reg W and other regulations would not change (FOMC minutes 10/16/13)
- Bank balance sheet growth: growth from unusually large deposit inflows or draws on existing lines of credit that temporarily reduce regulatory capital ratios will get handled through each bank’s primary supervisor, who will consider whether the bank is fundamentally sound despite the temporary decline in ratios (FOMC minutes 10/16/13)
- Fed actions: the Fed has discussed using outright purchases, securities lending, rollovers, repos to keep the fed funds rate in its target range, and discount window lending to address policy objectives. It may use reverse repo to provide unblemished collateral to the market or conduct repo to dealers. The Fed has also considered outright Treasury purchases or CUSIP swaps to support market functioning (FOMC minutes 10/16/13)
The unknowns after an X-date
- Success of Treasury auctions: If new auctions fail to generate enough proceeds to pay principal on maturing debt, and other available cash cannot cover the shortfall, the US defaults on the maturing debt; an auction could fail if one or more primary dealers failed to bid on their minimum required auction amount.
- Rating agency response: Since the US will be in default on other non-debt obligations or could miss principal payments without extending maturity, rating agencies may downgrade US debt.
- Repo market response: some lenders may amend collateral eligibility to avoid securities with interest or principal due during the repo term or securities with delayed coupon or principal, and Treasury repo costs may rise (FOMC minutes 10/16/13).
- Money market fund actions: money funds may sell securities with interest or principal due after the Treasury runs out of money or with delayed coupon or principal and choose to hold cash (FOMC minutes 10/16/13).
- Bank deposit growth: balances at custodian banks may rise if money market funds choose to hold cash (FOMC minutes 10/16/13).
- Bank liquidity coverage ratios: based on risk-based capital guidance, treatment of Treasury debt as a Level I HQLA and GSE MBS as Level II HQLA seems likely to remain the same.
- Insurer risk-based capital: NAIC treats obligations of the US government separately from rated debt. Unclear if that changes in the event of downgrade or default.
- Actions of fixed income market index providers: Outstanding US Treasury securities with a delayed interest payment will stay in all Bloomberg fixed income indices and will not be treated as defaulted. Securities with a delayed principal payment will be treated as matured on the original maturity date. If a secondary market develops for delayed payments on Treasury securities, those payments will not be eligible for a Bloomberg index. Bloomberg is actively discussing index treatment of Treasury debt if the US gets downgraded below investment grade but has not released a statement yet (Bloomberg INP, 3/16/23).
- Actions of central banks and sovereign wealth funds: the investment goals of central banks and sovereign wealth funds vary from stabilizing the domestic currency to diversifying national wealth to investing for future generations. There may be no uniform response. One of the more transparent, Norges Bank Investment Management, manages 30% of its portfolio against an index. The government bonds in the index, it says, “will normally have a high credit rating and be very liquid.” (Norges Bank website 5/10/23).
- The direction of rates: Rates markets would have to balance strongly competing interests. On one hand, portfolios triggered by investment guidelines or preference could choose to stay in cash or become forced sellers of Treasury debt, sending yields higher. On the other hand, Fed actions and sharp fiscal contraction from operating under the debt ceiling could drive expected growth and inflation down, sending yields lower. Rates might initially rise but then begin to fall if the debt ceiling remained in place and fiscal contraction continued.
- Credit spreads: Credit markets would likely price in at least temporary fiscal contraction without a lift in the debt ceiling, with credits that rely on government contracts affected the most.
- The value of the dollar: Past performance of the US dollar against other currencies may not be a good guide to valuation if the US crosses the X-date. The US dollar usually benefits from flight-to-quality, but this could get complicated by concerns about investing in US debt.
- For rates, get long rate volatility by owning at-the-money (ATM) or delta-neutral out-of-the-money (OTM) puts and calls. Given the conflicting forces on rates, hedge a cross into X-territory by getting long straddles or strangles on 5-year rates.
- For the dollar, get long USD volatility with ATM or OTM straddles or strangles.
- For credit spreads, add out-of-the-money puts on the S&P 500 or own protection on an investment grade or high yield credit index. Or reduce the cost of the S&P put by writing a delta-neutral or premium-neutral call.
- For relative value in credit. Add exposure to investment grade credit and reduce exposure to high yield. Or add exposure to credits with limited or no revenue from government contracts and reduce exposure to credits that rely heavily on government revenue in healthcare, aerospace and defense, REITs, technology and other sectors.
Even though the chance of crossing an X-date this year looks vanishingly small for now, there be dragons. The Congressional Budget Office on Friday estimated the federal government would run out of money in the first two weeks of June. The time to plan is before the date instead of in the heat of the unexpected moment after.
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The view in rates
The Fed clearly sees policy as tight, as Fed Chair Powell noted in his press conference after the May FOMC. The latest Senior Loan Officers Opinion Survey suggests tighter bank credit is helping as well. And the uncertainty around the debt ceiling showdown will also likely tighten financial conditions. OIS forward rates continue to price steady fed funds through August and cuts of more than 50 bp into December. The market is clearly assigning significant weight to the possibility that tighter bank credit will magnify the impact of cumulative Fed hikes and drive cuts later this year.
The front end of the yield curve continues to show concern about a showdown over the US debt ceiling. Treasury Secretary Yellen’s notice that the federal government could run out of money by June 1 has made that day a bright line for Treasury bills maturing on or after that date. As of Friday afternoon, the bill maturing on May 30 trades at a mid-market yield of 3.18%% while the bill maturing on June 1 trades at 5.33%
Fed RRP balances continue to climb and closed Friday near $2.23 trillion, below the level of recent weeks. Money market funds have seen some small net outflows in recent weeks, which may explain the lower RRP balances.
Settings on 3-month LIBOR have closed Friday at 532 bp, down 1 bp from a week ago. Setting on 3-month term SOFR closed Friday at 507 bp, up 3 bp from a week ago. LIBOR and SOFR have stayed in a tight range in recent weeks.
Further out the curve, the 2-year note traded Friday at 3.98%, up 8 bp over the last week. With the Fed likely to hold at current levels longer than the market expects, fair value on the 2-year note is higher than current yields. The 10-year note closed at 3.45%, up 3 bp over the last week. Fair value on the 10-year note is lower than current yields. The Treasury yield curve traded Friday afternoon with 2s10s at -53, flatter by 7 bp. Expect 2s10s to flatten further. The 5s30s traded Friday morning at 33 bp, 3 bp flatter on the week.
Breakeven 10-year inflation finished the week at 219 bp, down 4 bp in the last week. The 10-year real rate finished the week at 127 bp, higher by 6 bp in the last week.
The view in spreads
Volatility has moved up slowly but surely since the collapse of SVB and the broadening of concerns about the ability of regional banks to hold onto deposits at a reasonable cost. Rising volatility has widened spreads on risk assets not only because of the uncertain economic and market impact of tighter credit but also because of resulting wider bid-ask spreads in markets. A debt ceiling showdown that goes right down to the wire should push up volatility, too.
The Bloomberg investment grade cash corporate bond index OAS widened over the last week to 171 bp. The MBS has generally seen good auctions of the pass-throughs formerly held by Silicon Valley Bank and Signature Bank. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 172 bp, wider by 7 bp from a week ago. Par 30-year MBS TOAS closed Thursday at 61 bp, also roughly unchanged from a week ago.
The view in credit
Failure to resolve the US debt ceiling with the US running a budget deficit would trigger a sharp fiscal tightening, likely slowing growth, pushing up unemployment and affecting all credits. That is an important event to watch.
Otherwise, 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.