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Congress to the Treasury Department: “Dance!”

Summary:
Once again, the Treasury Department finds itself tap dancing to avoid getting shot in the foot by Congress. And if you think the Federal Reserve is going to tighten this week (who doesn’t?), this little routine might not be fully reflected in short-term funding rates.The gun in the scenario above is the debt limit, of course. Remember that arbitrary statutory ceiling on the absolute amount of US Treasuries outstanding? You know, the relic of the Second Liberty Loan Act of 1917 that puts the United States at risk of a technical default and, somehow, is still a law today? Yes, that one, which was introduced in its modern form almost 80 years ago, according to Kenneth Garbade, analyst at the New York Fed and go-to Treasury market historian.(Really, the uninitiated should have a look at the

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Once again, the Treasury Department finds itself tap dancing to avoid getting shot in the foot by Congress. And if you think the Federal Reserve is going to tighten this week (who doesn’t?), this little routine might not be fully reflected in short-term funding rates.

The gun in the scenario above is the debt limit, of course. Remember that arbitrary statutory ceiling on the absolute amount of US Treasuries outstanding? You know, the relic of the Second Liberty Loan Act of 1917 that puts the United States at risk of a technical default and, somehow, is still a law today? Yes, that one, which was introduced in its modern form almost 80 years ago, according to Kenneth Garbade, analyst at the New York Fed and go-to Treasury market historian.

(Really, the uninitiated should have a look at the law. It just sets a number for the limit, it’s not even tied to a budget or a percentage of gross domestic product or anything.)

Luckily for the US — well, sadly, really — the Treasury has done this a few times in the past several years, so it’s built up some muscle institutional memory of the “extraordinary measures” that can be used to delay a breach of the ceiling. And it seems reasonable to say that there’s less risk of a technical default, since it’s unlikely that the Republican Congress will be tough on the Treasury now that there’s a Republican in the White House.

But even if extraordinary measures aren’t needed for long, the return of the debt ceiling means there’ll be a jump in outstanding bill supply the same day the Fed raises is expected to raise rates.

Here’s why: The Treasury has had to cut its cash balance to $23bn from $400bn over about three months, since it isn’t allowed to hold a buffer going into the debt ceiling’s reinstatement.

This has made T-bills — which are among the most money-like securities out there — relatively scarce, and left a surplus of cash with government money-market funds.* That in turn has pushed up demand for high-quality collateral, and led to higher valuations in Treasury bills, short-term collateralised loans, and even agencies’ short-term securities.

All this can be seen in the chart below, which shows the gap between 1) the rate on overnight collateralised loans between dealers and money managers and 2) the rate for overnight collateralised loans between the Fed and money-market funds. Dealers usually agree on higher rates with their clients than the Fed offers to money-market funds, for obvious reasons. But that trend briefly reversed earlier this year, and the spread remains narrower than normal:

Congress to the Treasury Department:  “Dance!”

The decline in issuance also seems to have helped alleviate the dollar’s persistent surge pricing as measured by cross-currency basis, especially the basis on USD assets swapped into euros. From Deutsche Bank:

Congress to the Treasury Department:  “Dance!”

Of course, the scarcity of T-bills wouldn’t be obvious if you’ve only been watching short-term rates. That’s because the Fed has sent unusually strong signals that it might decide to tighten in its statement on Wednesday, which has helped push rates up for bills maturing in less than a year.

Congress to the Treasury Department:  “Dance!”

The debt-ceiling suspension is also lifted that day, so the Treasury can issue more bills. Analysts expect the Treasury’s cash balance to grow to around $150bn, which will make that day a double-whammy: A jump in the amount of bills in circulation just as the Fed’s policy band is supposed to rise by a quarter-point.

Repo markets might not currently be reflecting that, since the year-to-date climb in rates “isn’t enough to cover both factors,” said Blake Gwinn of NatWest Markets (formerly known as RBS Securities) in an interview. Bill yields might not see the same effect, since demand should rise ahead of the end of the quarter.

So, even though the expected Fed hike was broadcast widely, don’t be surprised if short-term funding rates still jump that day.

In better news, the Treasury probably doesn’t have to think too much about the more creative options available to circumvent the debt ceiling, because the simplest of the extraordinary measures will probably last until autumn. (That’s arguably bad news for this blog’s copy. Trillion-dollar coin, we barely knew ye.)

To start, the Treasury last week suspended issuance of state and local government securities (SLGS), which are charmingly referred to as “slugs.” They help state and local governments manage their cash without running foul of laws that prevent them from investing bond proceeds in higher-yielding investments.

RBS NatWest’s Gwinn says a reasonable next step would be to stop reinvestments for the $224bn Government Securities Investment Fund. The fund is invested in a special class of nonmarketable Treasury security and rolled over daily.** The people who would lose from that scenario are the federal government employees who would miss out on a few months’ worth of returns in their retirement accounts, or however long it takes before Congress lifts the ceiling. Not ideal, but not a disaster, either.

The Treasury has other ways to manage its outstanding debt, like halting the investments of its emergency reserve fund (around $22bn held for currency intervention) and fiddling around with the reinvestment/issuance/etc of a pair of federal employee benefit funds.

No matter what the Treasury does, the best-case scenario is that we never have to deal with this nonsense again, since one political party controls the White House and Congress. But it seems a bit absurd that the most realistic way this happens is a reinstatement of the Gephardt Rule, which ties the debt ceiling to the annual budget, rather than a revamp — or dare we hope, a repeal — of the debt-ceiling rule.

Related links:
Federal debt and the statutory limit, March 2017 – Congressional Budget Office
Reaching the debt limit: Background and potential effects on government operations – Congressional Research Service
Two cents on the trillion-dollar coin, and a debt-limit schedule – John Cochrane, c. 2013
The coin as a negotiating strategy – FT Alphaville, c. 2013
Selling Treasuries is still not a valid political threat – FT Alphaville

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*And don’t forget, the amount of cash in government money-market funds has grown to $2.2tn from $1tn about a year ago as a consequence of as reforms to prime funds that led investors to withdraw money and led fund companies to change their offerings.

**OK, this option is somewhat interesting, because of the structure of the G Fund. The securities are almost like perpetual bonds, since they earn yield until the day you redeem your cash. Sure, the daily reinvestment means your returns might stop for a while if a debt ceiling pops up. But besides that, it seems like a pretty good deal!

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Alexandra Scaggs
Alexandra Scaggs is a markets reporter for the Wall Street Journal in New York. She writes about the U.S. stock market and investment trends. She also covers the business of markets research, writing on the calls, personalities and moves of high-profile analysts and strategists. Ms. Scaggs graduated from Washington & Lee University with a degree in business journalism.