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The imminent resumption of borrowing limits for the US government will leave Wall Street scrambling to park cash at the Federal Reserve, strategists warn, as investors face a worsening drought of ultra-safe, short-term securities.
Friday marks the end of a two-year suspension on the debt ceiling, which curbs the Treasury department’s capacity to issue new debt.
Few believe policymakers will risk a US default by failing to either lift the debt ceiling or suspend it once again. But as a new deal is thrashed out before a hard deadline expected in the coming months, the strains that have led money market funds and other investors to seek record-breaking relief from the US central bank this year are likely to get worse.
“It is a very slow moving train wreck,” said Gennadiy Goldberg, a rates strategist at TD Securities.
“The longer they delay raising the debt ceiling, the more Treasury has to [reduce] bill supply” leaving less debt to invest in, particularly on a short-term basis, Goldberg added. “What you are going to see is more and more pressure on money market rates, which in turn will put pressure on money market funds.”
Money market funds are designed to be highly stable investment vehicles and are used as a place for investors to stash their funds while they are sitting on the sidelines of other assets like stocks.
These funds, a bedrock of broader financial markets, typically hold very short-term debt that in normal times pays small but positive interest rates. The rush of cash into the financial system pushed some rates into negative territory earlier this year, leaving swaths of the industry that looks after $4.4tn in assets in the US unprofitable.
Raising the legal limit for federal government borrowing has become a bitterly partisan issue in the US in recent years, though the parties have always reached a late deal to avoid a default. Strategists expect a similar scenario this time around as the two political sides clash.
The Congressional Budget Office last week predicted that the Treasury is likely to run out of cash by October or November, once certain “extraordinary measures” the department could employ to give itself more headroom are exhausted.
The challenges that will crop up for investors in the run-up to this deadline — namely too much cash looking for a home and too few feasible securities to buy — are not new.
Excess reserves in the banking system have ballooned since the start of the year due in part to the Fed’s purchases of $120bn of Treasuries and mortgage-backed securities each month as part of extraordinary measures to support the economic recovery from last year’s Covid-19 lockdowns. The Treasury’s efforts to dole out funds associated with the Biden administration’s relief package passed in March have only increased the cash in the system.
That collided head-on with a shrinking supply of short-term bills in circulation, as the Treasury also sought to lengthen the maturity of its outstanding debt stock.
Morgan Stanley estimates that so far this year the Treasury has reduced the amount of outstanding bills, which mature in one year or less, by about $800bn, as the department’s cash balance has fallen below $590bn from roughly $1.6tn in January. The balance is set to slide further — with the Treasury targeting $450bn by the end of July and heading lower from there — which means another $250bn contraction in bill supply is expected by the end of September, according to the bank.
Strategists say the pullback in supply will ignite another surge in demand for the Fed’s reverse repo programme (RRP) facility, which offers select banks and investment groups a place to stow cash overnight.
The facility has drawn in record-breaking usage this year, but demand really took off in June after the US central bank started paying interest on the money held overnight as it grappled with sliding short-term interest rates. The move was aimed at supporting “the smooth functioning of short-term funding markets” and was accompanied by an increase to the interest it pays on excess reserves, which banks hold on deposit at the Fed.
According to Fed chair Jay Powell, the RRP facility has worked exactly as intended by serving as a relief valve for a financial system that is awash with liquidity.
Lou Crandall, chief economist at Wrightson Icap, believes demand could balloon to as much as $1.5tn, up from its previous record of $992bn seen at quarter-end in June, as the expected drop in short-term interest rates ahead of a debt ceiling resolution entices eligible money market funds and other participants. At 0.05 per cent, the RRP rate is often more attractive on a relative basis than investing elsewhere, said John Canavan, an analyst at Oxford Economics.
At this pace, strategists have begun to speculate when the Fed, which expanded the number of firms that could access the facility and raised the maximum amount that could be tapped in March to $80bn, may need to make further adjustments to account for forthcoming surges.
“With the current reserve environment, we are a long way off until there is not going to be a decent amount of RRP demand,” said Blake Gwinn, head of US rates strategy at RBC Capital Markets. For short-term debt, “this just becomes part of the landscape”, he added.