As the March 15 deadline approaches, Treasury bills could become increasingly volatile
In the first quarter of 2017, a newly minted Congress will be tasked with approving an increase in the US government’s debt limit — the so-called “debt ceiling” — which is set to expire on March 15, 2017. If the debt ceiling is not raised, the Treasury bill market could experience volatility as investors adjust to a potential reduction in the supply of Treasury bills.
What is the debt ceiling?
The debt ceiling is the total amount of money that the US government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds and other payments. These obligations currently include approximately $13 trillion of debt owed to bondholders, including everyone from individuals to foreign governments, plus roughly $5 trillion in debt the government owes to various government accounts like Social Security and Medicare trust funds.1 When all goes smoothly, the Treasury typically covers such debt service expenses by issuing new Treasury securities (up to the ceiling).
It is important to note that setting the debt limit is separate from establishing the Federal budget and spending limits. In other words, the debt ceiling does not authorize new spending, but allows the government to continue borrowing to cover its existing obligations. Since its introduction in 1917, the debt ceiling has been raised periodically without much fuss. However, in the past few decades, setting the debt ceiling has become a highly partisan battle, as both political parties have attempted to attach additional proposals and requirements to the bill. In November 2015, Congress agreed to extend the existing debt ceiling until March 15, 2017.
What happens if the debt ceiling is not raised?
If the debt ceiling is not raised in March, the Treasury’s cash balance, which is mandated by law, would need to decrease dramatically, which in turn means a sharp reduction in the need for Treasury bill issuance. The Treasury’s current cash balance is much higher than it has been in recent years, currently totaling around $340 billion, compared with around $152 billion as of the end of 2015.2
Indeed, in anticipation of this eventuality, the Treasury has already begun drawing down its large cash balance in preparation for meeting the mandate if necessary, and recent Treasury bill auctions have been scaled back. We at Invesco Fixed Income expect Treasury bill auction sizes to remain relatively low from now through the first quarter of 2017, putting potential downward pressure on Treasury bill rates.
If Congress fails to increase the debt ceiling by March 2017, the Treasury can implement “extraordinary measures” to avoid defaulting on its obligations. In fact, we estimate that such accounting techniques — which include halting contributions to specific government pension funds, suspending certain securities issued by state and local governments and borrowing money that has been set aside to manage exchange rate fluctuations — could give the Treasury enough leeway to delay raising the debt ceiling until around mid-2017. However, if no resolution occurs and the Treasury exhausts its “extraordinary measures,” we would expect interest rates on bills set to mature around the time of a potential payment default to cheapen significantly relative to rest of the Treasury bill curve, as investors would likely avoid owning those bills.
What happens if the debt ceiling is raised?
If the debt ceiling is raised, we would still expect to see a compression in Treasury bill rates across the yield curve. The Treasury would likely face a short window for increasing its Treasury bill issuance in order to build its cash balances back up to desired levels, potentially pressuring Treasury bill rates higher. But we believe this increased Treasury bill supply would be offset by strong demand from government money market funds, Treasury-only funds, and investors seeking liquidity for their portfolios. The Federal Reserve’s overnight reverse repurchase program (RRP) could support Treasury bill rates, but we believe this would be outweighed by demand from government funds and Treasury-only funds, which are not eligible for the RRP.
Money market rates face downward pressure despite debt ceiling battle
With the debt ceiling battle on the horizon, we could see volatility in Treasury bills in the coming months. Reduced net Treasury bill issuance could pressure Treasury bill rates lower as we approach the March 15 deadline and could put downward pressure on other money market securities such as agency securities and the repurchase (repo) markets.
If Congress raises the debt ceiling, we would still expect strong investor demand to keep rates low, but we would expect quite a bit less volatility. Therefore, despite some volatility likely due to uncertainty over the debt ceiling, we are constructive on Treasury bill rates over the next few months.
1 Source: Committee for a Responsible Federal Budget (Oct. 22, 2015). “Everything you should know about the debt ceiling.”
2 Source: Wrightson ICAP, LLC, as of Dec. 6, 2016, and Dec. 31, 2015.
Justin Mandeville
Portfolio Manager
Justin Mandeville joined the Invesco Global Liquidity team in January 2015 as a Portfolio Manager and is involved with the management of short-term Treasury, agency and repo securities. Mr. Mandeville began his career with Vanguard’s client relationship management group before transitioning to Vanguard’s Fixed Income and Money Market team. Mr. Mandeville earned his BS degree in business administration from Pennsylvania State University and his MBA, with a concentration in finance, from Drexel University.
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Countdown to the debt ceiling debate by Invesco
