Treasury Warns Debt Ceiling Deadlock May Squeeze Bill Market

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The U.S. Treasury said a possible deadlock over the nation’s debt ceiling may limit the supply of short-term government securities, hurting a bill market already strained by rising demand for the world’s safest assets.

The U.S. reached the statutory borrowing limit in March, and since then the Treasury has been taking extraordinary steps to continue to access debt markets and finance expenditures without breaching the ceiling. Treasury Secretary Jacob J. Lew said last week those special measures will probably last at least through October.

The Treasury, which decided to increase bill issuance in May to respond to higher demand and reduce the risk of dislocation and price squeezes, will have to limit the supply in coming months to avoid breaching the borrowing threshold.

“The Treasury has a strong preference to expand bill issuance, but Congress will force it to slash supply over the next few months,” said Lou Crandall, chief economist at Wrightson ICAP LLC, who expects the cut in bill supply to hit by early November. “The combination of rising demand and falling supply could make this bills squeeze particularly severe.”

In its quarterly refunding announcement Wednesday, the Treasury said it will sell $24 billion in three-year notes on Aug. 11, $24 billion in 10-year notes on Aug. 12 and $16 billion in 30-year bonds on Aug. 13. The offerings will result in a debt paydown of $3.2 billion and will refund $67.2 billion of privately held notes maturing Aug. 15, the department said.

August Break

“Demand is going to continue to increase,” Ward McCarthy and Thomas Simons, economists at Jefferies Group LLC, one of 22 primary dealers that trades Treasuries with the Federal Reserve, wrote in a note to clients Wednesday. “The conversion of prime funds, which currently hold well over $1 trillion in assets, to Treasury-only funds over the next two years suggests that a large amount of cash will flow into the front-end of the Treasury market.”

Congress can’t act on the debt ceiling until September at the earliest because lawmakers in the House have already left town for an August recess. The Senate, which is still in session, is scheduled to start its month-long break at the end of this week.

“As we go forward over the next couple of months and we’re operating under the constraints of the debt limit, the reduced supply of bills could exacerbate that mismatch between supply and demand,” Treasury Acting Assistant Secretary for Financial Markets Seth Carpenter said at a press conference Wednesday. “It’s clearly a risk, it’s clearly something we’re concerned about.”

While the bankers advising the Treasury discussed the advantages and costs of issuing more long-term debt and extending maturities, Carpenter said the benefits aren’t significant.

“When it comes to the calculations, the simulations suggest that that benefit is actually quite small,” he said. “That sort of presentation helps us think about the benefits, how big they may be, but we also need to think about their costs.”