As debt limit talks intensify, the US may have to quickly raise $1 trillion

As politicians in Washington negotiate over a deal on the debt limit, Treasury officials may soon have to clear another hurdle: issuing around $1 trillion of debt in about six months, according to estimates from the Short-Term Interest Rates Trading desk at Goldman Sachs.

The Treasury has been undertaking a series of extraordinary measures to keep the government from defaulting, and those efforts have distorted the supply of government debt. “In the event the debt limit is raised, there will likely be lot of debt that will come into the market” as the Treasury makes up for issuance that hasn’t taken place because of the debt ceiling, says Brandon Brown, a vice president on the Short-Term Interest Rates Trading desk within Global Banking & Markets.

We spoke with Brown about the Treasury market’s reaction to the impasse over the debt ceiling, the large amount of borrowing that’s expected to take place in the coming months and the investors who are likely to absorb that new debt.

What are you seeing in the Treasury bills market as we approach the deadline for raising the debt limit?

Treasury bills that are maturing before the end of May are considered safe, as Treasury Secretary Janet Yellen has stated the Treasury has enough money to fulfil its commitments at least until June 1st, but is unlikely to be able to fulfilment those commitments by June 15. As such, most market participants assume that the ‘X date’ by which Treasury would run out of funding is somewhere in early June — after June 1st, but before June 15th.

Therefore the bills that mature before the end of May, which are very, very short dated, are trading incredibly rich (at yields that are seen as very low). In outright yields, that could be around 3%, which is much lower than SOFR (Secured Overnight Financing Rate). SOFR and the federal funds rate are very comparable. They are both rates that the Fed tries to keep within their target range, which currently is 5 to 5.25%. In comparison, bills that mature in early June are deemed riskier because the Treasury might run out of cash and be unable to make those payments.

This has created a huge hump in yields. This week the Treasury issued a 21-day bill that matures right around when the market anticipates the X date to be, or shortly thereafter. That auction cleared at 6.2%, and that’s a very, very high yield because there’s a lot of risk premium being built into those early June dates.

When you continue to move further out on the yield curve into July, we assume the Treasury will have funding and will be able to make some payments. As such, Treasury bills maturing in July are being considered a little bit safer.

How does this compare with other debt-raising episodes, such as in 2011?

In 2011, the negotiations came right down to the wire and a deal wasn’t passed until two days before the projected X date. The bills complex didn’t really move until about a week before because the market effectively assumed that a deal would be reached.

Now, we’re in a little bit of a different situation. The moves have been more severe, and have occurred much earlier. We’ve had a few episodes — 2011 being the most notable where we did come close to missing payments — and so the market is more prepared for it, and it’s a little bit more advertised than it would have been in 2011.

Many market participants also argue that political polarization is much higher now than it was then, so the negotiations could be more drawn out, more difficult, and it could be harder to reach a deal. As such, the hump in the Treasury bills yield curve is much bigger and is being seen earlier than in past debt-raising episodes.

Congress has always raised the debt limit. Assuming they do so again, what happens after that?

In the event the debt limit is raised, we anticipate there would be a lot of a lot of supply to come into the market. So, step one is reaching a deal, and if a deal is reached the Treasury will likely have to issue the normal amount of debt that they would have issued if they hadn’t entered extraordinary measures. So right now, bill supply has been modestly lower than it would be in normal times. Because we’re in extraordinary measures, and we’re at that debt limit, bill supply will likely ramp up a little bit just to get to a normal pace.

Beyond that, we anticipate bill supply will exceed a normal pace because the Treasury will want to replenish their Treasury General Account. The TGA can be thought of as a checking account for the Treasury, which they don’t want at zero. For example, if for some unforeseen reason Congress wants to quickly pass a bill which involves government spending, Treasury wants the ability to facilitate that. They don’t want to have to go out and issue extra debt to be able to fund such an expenditure. They like some form of buffer.

It is the desk’s estimate that the Treasury will try to rebuild the TGA to about $600 billion or $700 billion of a standing balance. But then that’s on top of the normal issuance used for normal government spending. We believe the market’s estimates are actually a little bit above $1 trillion of bills, maybe up to $1.2 trillion of bills, to come. We predict the timeline of that supply is over the six months after the debt limit is raised.

Is the market well placed to absorb so much newly issued debt?

Banks still have excess reserves of around $3 trillion, and most economists would say that around $2.5 trillion would be kind of a binding level where the demand curve for reserves gets steep. So the bank reserves, they do have some buffer, but it’s probably not enough to take down all of the supply. As such, we predict most of the supply will be absorbed by money market funds which are effectively holding assets at all-time highs.

Money market funds also put a lot of money currently at the Fed’s RRP (Reverse Repurchase Facility), which has a rate of about 5.05%. The Fed uses that as an instrument to keep front-end rates within its target range. Money market funds have so much money at the RRP — that balance is a little bit over $2 trillion, and so there is enough money out there to absorb all the supply.

The question is how much bills need to cheapen for money market funds to want to buy bills instead of putting their money at the RRP? And in our estimate, the bill yields will need to cheapen such that they’re at least close to, if not higher than, the yields that the RRP offers.

Long story short, we think that the bill supply will be absorbed. We think money funds will be the primary ones to absorb it, but bills need to cheapen for the supply to be absorbed.

Do any investors see this as an opportunity?

You can split it up into different kinds of market participants. Money market funds have been the main buyer of bills. Banks have bought bills as well to some extent. But especially as we get more bill supply, money market funds will be the ones that need to absorb most of the supply, and they’ve been very risk averse. And so that’s why the kink in the bill curve exists. They will participate in the bills, but they’re just requiring a large concession in the bills that are at risk.

There have been some high-profile investors who have come out and said that there’s no way that the U.S. government is going to actually miss a payment, and that these bill yields are incredible, and it’s an incredible opportunity to buy. So I think it depends on what your risk profile looks like.

In the desk’s view, we estimate there is a 10% or less likelihood that the U.S. does miss a payment. And so some of the yields are starting to look fairly attractive, and as we get closer, if they go even higher, then certainly it could be an opportunity. But it depends on your risk profile.

This views expressed here do not represent a formal or official view of Goldman Sachs, but rather are solely the views of the author, which may differ from those of Global Investment Research.

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