Debt/Extraordinary Measures (Oct. 6)

Mike and Co.,

The season of surprises continues.  Along with a disappointing September jobs report, we got word  from Treasury last week that the debt limit deadline is now Nov. 5.

A look at the impact on markets and the political state of play.

Best,

Dana

———

Last week, Treasury wrote in a letter to outgoing Speaker Boehner that it needs the statutory national debt limit raised to avoid default a few weeks earlier than it previously had estimated:  “The ultimate date that Treasury exhausts extraordinary measures… could be sooner or later than November 5.”

The government actually reached its borrowing cap in March; since then, the Treasury has been deploying “extraordinary measures” to free up room to continue borrowing.  It looked recently like the well would go dry in late November or early December.
But, Lew said, “Over the past ten days, we have received quarterly corporate and individual tax receipts and additional information about the activities of certain large trust funds, including military retirement trust funds… receipts are lower than we previously projected, and the trust fund investments were higher than projected resulting in a net decrease of resources available to the United States government.”

The frontline risks are to government contractors, federal workers, taxpayers due refunds, veterans, seniors and anyone else to whom the federal government has a legal obligation.  This is to say nothing of the havoc that would be wreaked on the markets, even in anticipation, where a moral hazard is developing.

In July, GAO released an analysis of the impact of the October, 2013 debt limit impasse on the Treasury market and predicted a worse impact if that experience occurs again this year.   In 2013, investors reported taking the unprecedented action of systematically avoiding certain Treasury securities—those that matured around the dates when Treasury projected it would exhaust the extraordinary measures that it uses to manage federal debt when it is at the limit.

For the affected Treasury securities, these actions resulted in both a dramatic increase in rates and a decline in liquidity in the secondary market where securities are traded among investors.  In addition, there was unusually weak demand at the relevant auctions and additional borrowing costs to Treasury.  As a result, disruptions to the Treasury market from the 2013 debt limit impasse extended into other markets, such as short-term financing.

Investors said they are now prepared to take similar steps to systematically avoid certain Treasury securities during future debt limit impasses.  Market participants said market reaction to future impasses could be more severe because of changes in market practices since the financial crisis and because of contingency plans that many investors now have in place.

Significant damage to markets for Treasury securities and other assets would affect not only institutions, but also individuals.  While increased rates on Treasury securities in the secondary market affect the amount of return on investment for private investors, changes in the rates paid at Treasury auctions affect the amount that Treasury—and ultimately the American taxpayer—pays in interest on federal debt.

For the Fed, a timely debt limit hike would take the issue off the table as a factor regarding a December rate increase.  Most members of the FOMC, including Chair Yellen, seem keen to lift rates at the December meeting so the new deadline makes such a lift then somewhat more likely.  But if there is some kind of accident resulting in the first ever U.S. default (or anything close to it) it’s likely to turn markets upside down, bring the economy to a halt and make it impossible for the Fed to move off its emergency footing.

Presidential politics could complicate Senate consideration of debt limit legislation.  Several of the hard-line conservatives who fought against raising the debt ceiling two years ago are now running for president and have already begun stirring controversy in the Senate.  All eyes will be on Sens. Cruz, Paul and Rubio as the deadline nears. Cruz filibustered the last debt limit hike in 2014 but neither he nor his fellow presidential contenders have weighed in on this year’s pending debt hike.  An open question is how much the debt limit should be increased.   It would take an increase of more than $1 trillion to take the issue off the table until after next year’s elections.

A transition from a lame-duck Speaker to an untested one seeking to avoid Boehner’s fate, a GOP presidential primary season heating up, and the leftover budget negotiations on deck — it is in this context that House will take up the debt limit later this month.  The last standoff in 2014 ended when Democrats in the Republican-controlled House delivered the majority of votes needed to pass a standalone measure to increase the borrowing limit.

Speaker Boehner, who departs at the end of the month, has said he wants to “clean up the barn” for his successor, but it’s not clear how far he can go in negotiations as a lame-duck Speaker.

President Obama has repeatedly said he will not negotiate the debt limit, but congressional Republicans in the past have pressed for spending cuts in exchange for raising the debt ceiling.

Meanwhile, the only action on the issue this year in Congress was on September 10, when House Financial Services passed Rep. Tom McClintock’s (R-CA) H.R.692.  The bill requires Treasury, once the debt limit is reached, to issue special debt obligations to pay principal and interest on debt held by the public and the Social Security Trust Fund, thus prioritizing entitlement benefits over, say, interest payments on debt held by China.

The administration, promising to veto this bill, warned that it “would result in the Congress refusing to pay obligations it has already agreed to. American families do not get to choose which bills to pay and which ones not to pay, and the United States Congress cannot either without putting the Nation into default for the first time in its history.”

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