The Debt Limit with Complications from Money Market Funds

Abstract

Debt limit negotiations often go down to the wire, generating headline risk and investor uneasiness. The yield on T-bills maturing around default date may be substantially higher than those maturing in neighboring months. The exponential growth in government money market funds since the 2016 regulatory reform increases contagion risk should shareholders and portfolio managers begin to sell. We advise investors to develop additional portfolio liquidity through US agency discount notes and highly rated corporate commercial paper. Institutional cash investors should manage their government fund balances with an eye towards the funds’ outsized influence on market liquidity.

Introduction

The congressional fight over the national debt limit has captured the attention of financial professionals since the limit was reached last March. While financial markets have endured at least three similar high-wire acts in the last six years, causing the federal government to nearly default on its debt obligations, this year’s debt limit fight involves a new phenomenon for institutional cash investors. The money market fund reform that took effect in 2016 resulted in dramatic asset migration from prime to government funds. The substantially larger exposure to the government sector through indirect means poses new risks to the treasury community in addition to those faced in previous debt limit fights.
The just-announced deal between President Donald Trump and Democratic leaders in Congress likely will push the debt limit fight by three months to mid-December. The threat of a failed final agreement, of course, remains. In this credit commentary, we provide a refresher course on the debt limit and how investors have reacted to the threat of technical default by Treasury securities. We offer reasons for investors to take special notice of the current and future rounds of debt limit fights in light of the larger presence of government fund assets in a treasury organization’s liquid balances.

What Is the Debt Limit?

The government debt limit, or debt ceiling, is a legislative limit on total federal government debt beyond which the US Treasury is not allowed to issue new debt. Under Article I Section 8 of the US Constitution, Congress must authorize all borrowings to fund the federal government. Congress authorized each debt offering until 1917, when it established an aggregate limit (ceiling) to provide more flexibility to finance the country’s involvement in World War I. The debt limit legislation underwent amendments and limit increases over the decades to accommodate increases in deficit spending.

What Happens when the Debt Limit Is Reached?

Without reauthorization by Congress to raise the limit, the US Treasury faces the risk of defaulting on its outstanding debt, seeing its sovereign credit ratings downgraded, facing substantially higher borrowing costs and having its ability to borrow from the public severely curtailed.
The Treasury may engage in “extraordinary measures” by temporarily withholding payments to certain internal accounts under its control to free up some additional borrowing capacity. These measures buy some time for Congress to reach a deal to raise or re-suspend the debt limit.

How Did We Get Here?

The debt limit has been raised by Congress 78 times since 1960. Serious debt limit fights in Congress were infrequent in the past until after the financial crisis of 2008, when government borrowing was increased substantially. The fights became increasingly politicized when politicians from opposing sides used the risk of federal debt default as leverage to extract political gains.
In 2011, the debt limit fight reached a crisis point of near default on public debt, which resulted in the US government debt losing the coveted AAA credit rating from Standard & Poor’s. A last minute deal increasing the limit set the stage for another debt limit fight in early 2013. The resolution of that crisis planted the seeds for yet another one in late 2015.
The re-suspension of the 2015 limit expired on March 15, 2017, at which time the limit was reset to $19.809 trillion. The Treasury has since employed “extraordinary measures” as Congress works to raise or re-suspend the limit again.
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