The Debt-Ceiling Fiasco May Be Over, But The Market Impact Is Just Starting

After weeks of wrangling, the US finally passed legislation earlier this month that lifted the debt ceiling, effectively preventing a potentially disastrous default. But investors look set to shift from fearing that the US wouldn’t raise its debt limit to worrying about what the increase means for short-term bond yields, banks, and the wider economy. And just when you thought it was safe to stop fretting about the US government’s finances…

What’s happening exactly?

Ever since mid-January, when it hit the $31.4 trillion debt ceiling, the Treasury Department has been using special accounting measures to make payments on all federal obligations. It’s also been running down its cash balance, which dropped below $23 billion at the start of the month – a dangerously low level that hadn’t been reached since October 2015. But now, following the resolution of the debt-ceiling dispute, the Treasury Department can seek to rebuild its cash balance to more normal levels by issuing a boatload of short-term debt (Treasury bills).

The Treasury’s cash balance was hovering near an eight-year low before the debt ceiling was raised. Source: Bloomberg.

How much debt is the Treasury expected to issue this year?

It depends who you ask, but the general consensus is that it’ll issue more than $1 trillion worth of short-term debt, which would be the biggest total sales of Treasury bills in history outside of crises such as the 2008 financial meltdown and the pandemic in 2020. Bank of America, for example, anticipates that the Treasury will need to borrow about $1.4 trillion from June to December – seven times the average amount for the same period from 2015 to 2019. JPMorgan, meanwhile, estimates $1.1 trillion by the end of 2023, with $850 billion in net bill issuance over the next four months alone.

What’s the expected impact of all this debt issuance?

The coming flood of debt sales is set to put downward pressure on Treasury bill prices, leading to higher short-term bond yields, which have actually already begun creeping up in anticipation of the increased supply. Making matters worse, the supply shock comes at a time when the government is running a significant budget deficit, which puts pressure on the Treasury to step up borrowing even more. At the same time, the Federal Reserve (the Fed) is winding down its bond holdings, in contrast with the recent past, when it was a huge buyer of government debt. That’s expected to exacerbate the issue even further. All in all, Bank of America estimates that the issuance wave could have the same economic impact as a 0.25 percentage point interest-rate hike from the Fed.

The big worry now is that as the returns on short-dated government bonds head higher, it’ll lead to a further exodus of bank deposits as customers opt for higher-yielding alternatives. Banks have already lost nearly $850 billion in deposits so far this year. In contrast, cash parked at money market funds (MMFs) reached a record $5.4 trillion at the end of May – up from $4.8 trillion at the start of the year. MMFs invest in low-risk, highly liquid, short-term debt securities like Treasury bills. And, in contrast to banks, MMFs are quick to pass on higher interest rates to customers, in the form of higher yields.

Money market fund assets swelled to a record high at the end of May. Source: Bloomberg.

To see how this could impact the wider economy, recall that banks take in money in the form of customer deposits and then lend it out again as loans. These deposits are a bank’s main source of funds – and typically the cheapest. So if Treasury bills and MMFs remain a more appealing option for savers than deposit accounts, banks may be forced to rely on costlier sources of funding, reduce their lending activity, or some combination of both. That’ll accelerate the withdrawal of credit, which is the lifeblood of the economy. When the availability of credit declines, it causes consumer spending and business investment to plunge, which would further tighten the screws on an economy that many experts already see heading for a recession.

Why should you care?

While the resolution of the debt ceiling issue is generally good for markets as it removes a key risk, it presents another challenge for the lending industry as it could amplify the existing pressures on the banking system. So from an investment point of view, it might be best to steer clear of financial stocks for the time being. MMFs, on the other hand, are offering yields of close to 5% and could head higher still as the Treasury embarks on a short-term debt-selling spree. During these times of economic uncertainty, cash is king. And cash held at MMFs can offer attractive, low-risk returns, immediate liquidity, diversification benefits, and a cushion against potential losses. To learn more, I discuss the key roles cash can play in a portfolio – and dig into those funds – here.