America hits its debt limit again. The countdown starts

The United States hit its $31.4 trillion statutory borrowing limit on 19 January, and Treasury Secretary Janet Yellen began the "extraordinary measures" that keep the government paying its bills. Markets shrugged. Most investors treat the debt ceiling as another episode of Washington theatre that will end, as it always does, with a deal at the last minute. That view misses what is happening in the money markets as the Treasury General Account (TGA) is run steadily down toward zero.

How the clock started

The current limit was set in December 2021, when Congress raised it by $2.5 trillion in the hope of pushing the next fight past the midterm elections. It did, and the midterms then handed the House of Representatives to Republicans with a narrow majority, many of whose members want spending cuts as the price of any increase. In her letter to Congress, Ms Yellen said the extraordinary measures were unlikely to be exhausted before early June. That date, rather than the one just passed, is the real deadline, and it will move with tax receipts.

Where the cash goes

Under extraordinary measures the Treasury stops issuing new debt and spends the cash it keeps at the Federal Reserve. As the TGA shrinks, that money lands in commercial banks' reserves, and hundreds of billions of dollars of it will get there before this is over.

The mechanics are simple accounting. The measures themselves are bookkeeping moves inside government, such as suspending investment in certain federal employee retirement funds, which create headroom under the limit without borrowing from the public. The Treasury then pays pensions, salaries and contractors out of its account at the Fed. When those payments are deposited, the recipients' banks gain reserves at the central bank, one for one with the fall in the TGA.

QT, partly undone

This runs directly against the Fed's quantitative tightening programme, blunting the drain on liquidity that was meant to tighten financial conditions. Risk assets have rallied in part because the debt ceiling has handed wholesale funding markets an accidental cushion of cash.

The timing is awkward for the central bank. Since September the Fed has been allowing up to $95 billion a month of Treasuries and mortgage bonds to mature without replacement, a process that shrinks reserves by design. For as long as the TGA is falling, the Treasury is pumping reserves back in, so the net effect of monetary tightening on bank liquidity is smaller than the headline pace of runoff suggests. Equities and credit spreads, which respond to liquidity as much as to rates, have enjoyed the difference since the start of the year.

Why the ending hurts

The danger lies in the ending rather than the drawdown. Once Congress raises or suspends the limit, probably amid a political crisis in the summer, the Treasury will have to rebuild its cash pile at once, and it will do so by selling a flood of Treasury bills.

The political crisis itself carries costs even if default is avoided. In August 2011 a deal was struck days before the deadline, yet Standard & Poor's still stripped America of its AAA rating and stocks fell sharply in the following weeks. Brinkmanship leaves bruises whether or not the government actually misses a payment, and a House majority this thin gives any small faction the power to drag the fight out.

A bill glut by summer

Selling $500 billion to $1 trillion of bills within ninety days would pull cash out of the banking system, push reserves lower and create a shortage of room for the new collateral almost overnight.

There is a recent precedent for what happens when reserves get tight faster than expected. In September 2019, weeks after a debt-limit suspension had allowed the Treasury to rebuild its balance, a corporate tax date and heavy settlement of new Treasury issues coincided, and overnight repo rates spiked far above the Fed's target range. The Fed had to intervene with emergency repo operations and later began buying bills to restore reserves. That episode showed that the level at which reserves become scarce is found only by crossing it.

The case for calm

The strongest objection is that this time there is a buffer. Money market funds have parked more than $2 trillion at the Fed's overnight reverse repo facility, and if new bills offer a better yield they would buy them with that cash rather than with bank deposits. In that case the TGA rebuild would mostly drain the reverse repo pile, leaving bank reserves largely intact. It is a serious argument, and it probably means a repeat of 2019 in overnight markets is unlikely.

But the shift depends on price. To lure money funds out of the facility, bills must yield more than the Fed pays on it, which means bill yields rising and short-term funding costs climbing just as the Fed is still tightening. Not all bill buyers are money funds, either. Banks, companies and foreign holders who pay out of deposits will still draw down reserves, and the pace of issuance matters as much as the total.

The distribution of the pain is fairly predictable. Savers and money market funds would gain, earning higher yields on short-dated paper. Banks, especially smaller ones that lean on deposits, would lose, since depositors who move cash into bills or into funds that buy them take reserves with them. American banks have already been losing deposits as rates rose, and a hurried rebuild of the TGA would add to that pressure just as deposit costs climb.

The signals are public and frequent. The Treasury's daily statement reports the TGA balance every business day, the Fed publishes reverse repo usage each afternoon, and the quarterly refunding announcement in early May will set out borrowing plans for the summer. If reverse repo balances fall sharply as bills are issued, the calm camp is right; if bank reserves fall instead, the squeeze has begun.

The debt ceiling adds cash to markets now and will take it back fast once a deal is signed, most likely in the summer. Holders of risk assets should expect the relief to reverse in the weeks after that vote. The likeliest victims are the assets that have gained most from easy liquidity this year, such as speculative technology shares and lower-rated credit, which could give back a good part of their early-2023 rally by the end of the third quarter.