We contemplate what happens next if the government can’t reach a deal before Dec. 8
The Treasury market received a reprieve in September when the White House and Congress agreed on legislation coupling hurricane relief funding with a suspension of the debt ceiling until Dec. 8.1 The agreement puts off a potentially contentious political debate and keeps the government funded until at least year-end. However, markets have now turned their focus to December and beyond. What should we expect to see in the Treasury market if a new debt ceiling deal can’t be reached by then?
September’s agreement calmed the markets — for now
Although the markets would have preferred a longer extension, in line with previous debt ceiling agreements, the three-month deal was sufficient to calm the Treasury bill market. Before the extension, uncertainty over the government’s ability to honor its obligations had caused yields on 1-month Treasury bills maturing in early October to rise sharply to around 1.3%.2 After the agreement, auction yields stabilized at around 0.97%.3
If the debt ceiling is not raised before Dec. 8, the market’s next important focus will be on speculation over when the Treasury may run out of funds — the so-called “drop-dead” date. The timing of the drop-dead date is dependent on how long the Treasury can fund itself using certain legal “extraordinary measures” (such as halting contributions to certain government pension funds and borrowing money set aside to manage exchange rate fluctuations) as well as the amount of cash it nets during tax season in early 2018. The timing is important because we expect uncertainty around the drop-dead date to cause a repeat of the Treasury market dislocation seen before the extension agreement.
What do the extension and drop-dead date mean for the Treasury market?
Under the extension, the Treasury has increased its issuance of bills, which have been quickly absorbed by the market and have provided a boost to the Treasury’s depleted cash balances. This increased issuance, combined with a possible Federal Reserve rate hike in December, has helped boost yields in recent 3- and 6-month Treasury bill auctions. Invesco Fixed Income expects these dynamics to keep Treasury bill yields elevated in the fourth quarter.
The extension agreement also stipulates that the Treasury’s cash balances on Dec. 8 must equal their Sept. 8 level — roughly $70 billion.1 This will impact the amount of Treasury bills issued until then and, therefore, Treasury bill rates. As we head into December, the Treasury will likely be managing its bill issuance to gradually bring its cash balances down to the $70 billion level. We expect it to accomplish this by reducing the size of its bill auctions, which we anticipate will put downward pressure on shorter-term Treasury bill yields. After Dec. 8, the Treasury will likely resort to extraordinary measures to fund the government, if a new debt ceiling deal is not reached. Given the political challenges of the debt ceiling issue, we would not expect a final deal before Dec. 8. We expect some volatility in Treasury bill yields from now until the debt ceiling issue is resolved. While this could potentially happen in December, we believe the first quarter of 2018 is more likely.
What factors influence the drop-dead date?
Some of the key factors that influence its timing include:
- Extraordinary measures and net tax receipts. We believe extraordinary measures represent just below $300 billion in available funding resources. We expect these measures to allow the Treasury to fund the government until late February or early March. But this depends on net tax receipts. For example, if tax refund payments are high in January and February, the drop-dead date could be earlier than expected.
- Tax reform. The terms and timing of proposed tax legislation could impact the Treasury’s financial position. Details of the plan are currently limited, but some political strategists estimate that a tax reform bill could be passed in late November or early December.
- Hurricane damage. Insurers are still assessing the damage to Houston, Florida and Puerto Rico from Hurricanes Harvey, Irma and Maria, and the amount of federal spending that will be allocated to these regions is still unknown.
Conclusion
Although it is too early to pin down exactly when the Treasury could exhaust extraordinary measures, Invesco Fixed Income is closely monitoring the factors detailed above and is cautious on Treasury bills scheduled to mature around the late February/early March time frame, due to the potential for volatility if a deal is not reached and extraordinary measures to fund the government run out.
Read more of our analysis on the debt ceiling issue: The US debt ceiling saga returns.
1 Source: US Senate Committee on Appropriations, Sept. 6, 2017
2 Source: Dept. of the Treasury, Sept. 5, 2017
3 Source: Dept. of the Treasury, Sept. 12, 2017
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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Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
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