May 15, 2023
US Debt Ceiling Impasse Threatens Money Market Funds, Financial Stability
The current crisis in US regional banks has caused a massive flight of bank deposits to money market funds (MMFs) offering higher interest rates. But money market funds are exposed to one of the biggest risks facing the global economy today: the possibility that the United States will exceed its debt limit and default on its debt.
Over the past year, bank deposits fell by almost $1 trillion while the assets under management (AUM) of the Monetary funds increased by $700 billion. Money market funds were also growing before the banking crisis: assets under management have increased by $1.7 trillion since the start of 2020, reaching $5.7 trillion today. Because money market funds invest largely in U.S. Treasuries, their status as a safe and attractive alternative to bank deposits would be at risk if the impasse over the national debt ceiling cannot be resolved in time. Exceeding the debt ceiling would call into question the government’s ability to meet its obligations from June 1. known as X-date when the Treasury Department has exhausted all extraordinary measures to avoid exceeding the $31.4 trillion debt ceiling. Even if the the impasse is resolved at the last momentAs market participants currently anticipate, an increased likelihood of government default would increase uncertainty and further disrupt already stressed financial markets. The final risk of a complicated and prolonged debt ceiling standoff is higher this time than before – and money markets will be the first to react if a deal is not reached in time.
Why money market funds are at risk
Money market funds are vulnerable to disruptions in the Treasury market because they hold many Treasury bonds. In particular, government money market funds—with $4.4 trillion in assets under management—split their portfolios almost equally between Treasuries and loans to the Fed through the banking network. Day-to-day repo facility. Under this facility, money market funds can lend money to the Fed on a daily basis, taking U.S. Treasury securities as collateral and agreeing to resell them at predetermined rates. The Fed’s Reserve Repo Facility has increased significantly in recent years, reaching $2.2 trillion in volume NOW.
As date basis, a record level compared to less than 20 basis points. points normally. This exceeds the CDS spreads of Mexico, Brazil and Greece. Investors also avoided Treasuries maturing right after X date, which pushed up their yields. For example, during the last auction on May 4, yields on one-month Treasury bills due June 6 jumped to 5.76 percent, or 240 basis points more than two weeks ago. Such a sharp and sharp rise in yields depressed the prices of fixed-income instruments like Treasuries, leading to mark-to-market losses for money market funds. Depending on the composition of their portfolio and their risk management practices, some money market funds could suffer losses sufficiently visible to bother their clients who expect stable values from these funds.
Additionally, if the debt ceiling is not raised in time to avoid a default, the United States’ credit rating would be downgraded. downgraded to Restricted Default (RD) and the affected Treasury securities would enjoy a D rating until the default is corrected. Even if the government prioritizes servicing its debt ahead of other obligations to avoid a default – a politically controversial move – this would not be consistent with an AAA rating. A major agency, S&P, has already downgraded the United States in 2011.
In short, possible mark-to-market losses and rating downgrades of Treasury securities, the primary assets held by money market funds, would generate anxiety among money market fund clients, likely prompting some to move their money elsewhere. (Much of it could be directed to the big banks, which would further accelerate the consolidation of the U.S. banking system.) Although any capital outflow could be curbed to some extent by the control systems and liquidity fees applied by money market funds Failure to manage capital outflows in an orderly manner would nevertheless increase uncertainty and a sense of nervousness in financial markets, already struggling with the regional banking crisis, high interest rates and the credit crunch. Adding a run on money market funds to increase market turmoil could trigger a deeper recession than expected. For this reason, the negative financial and economic impacts of the current debt ceiling impasse could be more substantial than those of previous episodes in 2011 and 2013.
Uncertainty at the wrong time
Money market funds can respond to the uncertainty surrounding the status of Treasuries after date However, the more monetary funds lend to the Fed, the more liquidity is withdrawn from the financial system, worsening the effects of quantitative tightening (QT) that the Fed has been implementing since June 2022 to reduce its holding of government securities by $95 billion per month. This would make it more difficult to assess the overall effects of the Fed’s tightening policy, both for the Fed itself and for market participants, thereby increasing uncertainty about the future economic outlook.
Political wrangling over the national debt ceiling has increased uncertainty at the wrong time and is helping to increase the risks of a severe recession. Beyond the short-term outlook, the recurrence of debt ceiling “mini crises” would erode the reliability, predictability, and reliability of the U.S. government, potentially causing it to lose its AAA rating and increase its financing costs. . More fundamentally, the practice of using the debt ceiling as a political tool to modify or terminate federal programs approved by previous Congresses reflects poor governance in the United States, despite the fact that the U.S. public debt-to-GDP ratio is too high and needs to be reduced. over time. The United States’ failure to adopt sustainable fiscal policy in an orderly manner will carry an increasingly visible cost in diminishing the effectiveness and credibility of the U.S. government, with negative implications for the broader economy.
Hung Tran is a nonresident senior fellow at the Atlantic Council’s Center for Geoeconomics, former executive managing director of the Institute of International Finance, and former deputy director of the International Monetary Fund..
At the intersection of economics, finance and foreign policy, the Center for Geoeconomics is a translation center whose goal is to help shape a better global economic future.
Further reading
Image: Moody black and white image of the US Capitol