The front end of the Treasury curve is flashing red because of the possibility of another black swan event—the threat of default on Treasury securities on or around Oct. 18.
Interest rates on Treasury bills with mid-October maturities have increased as investors have built cash positions.
Investors have begun dumping their safe-haven assets in favor of holding cash, causing interest rates on Treasury bills with mid-October maturities to increase.
Although our base case is that a potential debilitating financial crisis will be avoided at the last moment, investors are setting up for another dance along the precipice of disaster caused by the political sector.
While this should not happen at a time when the Federal Reserve has been steadfast in keeping rates at the zero bound, the probability that there may be a delay in payments on Treasury notes has resulted in stress at the front end of the Treasury curve.
One could argue that investors are more worried about inflation than they are about full employment. Yet a quick look at pricing in the fixed-income market points to something else. Rates for Treasury notes maturing in November moved only two basis points higher, while the interest rate for the T-bill maturing on Oct. 21 has increased by 12 basis points, according to Federal Reserve data on Bloomberg.
We are quickly approaching a replay of the stress at the front end of the market and possible turmoil throughout financial asset markets that occurred during the U.S. debt-ceiling crisis in 2011.
This implies that investors have grown increasingly wary of holding a security with the potential of not being paid, resulting in a rush to cash holdings and an excess of reserves held by banks.
To drain those reserves, the Federal Reserve set up a reverse repo facility in the years after the financial crisis. During episodes of excess cash, which can imply an unwillingness to borrow or to lend, the Fed can sell overnight repurchase agreements to the banks with a modest but guaranteed return. The rate on those contracts is now 5 basis points.
In the six months since March, when the threat of a debt crisis and the government default on its debt were still vague, the facility has grown from draining less than a billion dollars per day to selling securities at a rate of $1.4 trillion per day as of the first week of October.
Still, are T-bill rates bound to increase regardless of the resolution of the debt-ceiling crisis? After all, how many times are investors willing to put up with a government that shows itself unwilling to repay its debts? Shouldn’t investors require a higher rate of return for holding a riskier security, than, say, a German or a Japanese bond?
Our analysis shows that 3-month T-bill rates barely budged off the constraints imposed by monetary policy during the 2011 and 2013 episodes of debt-ceiling negotiations and government shutdowns. Instead, the additional default risk was applied to longer-term securities.
This suggests that the increase in T-bill rates is likely to be short-lived whether or not the debt ceiling drags on. The increase in the T-bill rate is probably a harbinger of the potential damage to commerce caused by widening money market spreads and a possible freeze in commercial lending should this turn into a full-fledged financial crisis.
Any downgrade of public debt will have an effect on the cost of corporate debt—and therefore economic growth—and an increase in the cost to consumers and taxpayers of servicing both private and public debt. Investors and policymakers need to take this seriously.
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