What the debt ceiling could mean for interest rate markets

The debt ceiling debate in Congress intensifies and markets begin to price US debt by the end of the year. The Treasury is spending $ 1.5 trillion in cash, the lowest level in recent times. The Federal Reserve’s reverse repurchase activity is at an all-time high, to mop up treasury cash spending. In November, the Treasury could reduce its record level of coupon issuance, and the Federal Reserve is considering reducing its asset purchases potentially at the same time.

The debt ceiling

Total US Treasury borrowing is capped at $ 28.5 trillion, according to the Congressional Budget Office. Since 1960, Congress has acted 78 times to permanently increase, temporarily extend, or revise the definition of the debt limit. Given the spending needs of the US government, various estimates suggest that the Treasury may have difficulty servicing its debt from late October or November. To fight against the reduction in borrowing capacity, the Treasury announced in early August a series of “extraordinary measures” to avoid “failure to meet its obligations”. These include the suspension of payments on certain retirement accounts and a reduction in the issuance of certain securities of intergovernmental agencies.

Nonetheless, the market began to price a small premium, as can be seen in Treasury bills and euro credit default swaps (CDS).

Source: Federal Reserve System Board of Governors (US), retrieved from FRED, Federal Reserve Bank of St. Louis, August 30, 2021.

Source: Bloomberg

Source: Bloomberg

Treasury futures can help overcome this potential problem to maintain proper risk management. The construction of Treasury term baskets is important and consists of many issues.

Another pricing area to watch out for is the spreads between the United States and the banks. If stress continues to build up for US funding, investors can monitor and manage risk using CME Group futures on SOFR (US Treasury funding) and the new CME Group BSBY (bank funding) futures contract. .

Finally, the new Micro Treasury Yield futures contract – which has a final settlement to the BrokerTec benchmark – offers yet another opportunity to invest in ongoing security.

Additional Silver Levels

When the Treasury issues debt or receives tax payments, it deposits its cash with the Federal Reserve Bank of New York into its General Treasury Account (TGA). As the Treasury spends its liquidity, this money enters the economy where it will eventually increase the level of deposits in banks. These additional levels of liquidity in the economy can lower the level of short-term interest rates for pension and SOFR yields. In order to avoid this, the Federal Reserve actively manages the level of liquidity and short-term yields by draining money through its reverse repurchase program. The Fed lends securities from its Securities Open Market Account (SOMA) for a short period of time, and in return receives money.

Over the past few months, we have seen a marked reduction in cash outflows from TGA and the reverse repurchase program. The TGA was $ 1.8 trillion, and as of August 26 it was $ 239 billion, lower than pre-pandemic levels. This demonstrates the extraordinary steps the Treasury is taking to stay under the debt ceiling.

Source: Federal Reserve System Board of Governors (US), retrieved from FRED, Federal Reserve Bank of St. Louis, August 30, 2021.

Source: Federal Reserve System Board of Governors (US), retrieved from FRED, Federal Reserve Bank of St. Louis, August 30, 2021.

Reduction and reduction of the issuance of coupons

The CME TreasuryWatch tool provides a comprehensive overview of the major fiscal and economic drivers of the US economy. The many traceable items include the huge amount of treasury coupon issues that have taken place over the past 18 months.

However, the amount of coupons issued could decrease as early as November 2021, according to an August 3 recommendation to the Treasury Secretary from the Treasury Borrowing Advisory Committee (TBAC). Key findings include: “Maintaining current coupon auction sizes would result in a T-bill share falling to near zero by 2026, highlighting the degree of overfunding below current auction sizes.” The target range for issuance of treasury bills is between 15% and 20%. In order to avoid such a situation, the TBAC recommended that starting in November, the Treasury reduce coupon levels by $ 18 billion per quarter on the following coupons:

“2, 3 and 5 year reductions of $ 2 billion per month. The Committee also recommends reductions of $ 3 billion in 10-year security and $ 2 billion in 30-year security for new issues and re-openings during the quarter. For 7- and 20-year securities, the Committee recommends cuts of $ 3 billion and $ 4 billion.

Simple supply and demand suggests that fewer coupon issuances could lower rates, as similar demand for these securities responds to a lower supply of issued coupons.

To potentially offset a reduced number of coupons, one could reduce the $ 120 billion in monthly treasury purchases ($ 1.4 trillion per year) ($ 80 billion) and mortgage-backed securities ($ 40 billion). dollars) that the Federal Bank of New York performs.

A phase-down estimate could reduce purchases by $ 6 billion per month and maintain them for the foreseeable future, thus offsetting the reduced coupon issues mentioned above. A more aggressive plan would decrease by $ 5 billion per month. An even more aggressive reduction path could cut purchases by $ 10 billion per month and stop buying after a year. Even in this aggressive scenario, the SOMA account would still grow by $ 700 billion. One ultra-aggressive scenario includes a reduction of $ 15 billion per month – ending purchases within eight months while removing $ 420 billion in assets.

Source: Federal Reserve, projections by CME Group Research and Product Development

Source: Federal Reserve, projections by CME Group Research and Product Development

As fall approaches, a number of fiscal and monetary hot spots below the surface could start to shift and pose increased risk for investors. Market participants will be watching closely and effective risk management will be essential.

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