Memorial Day: The debt deal is done. Now comes the bill

Negotiators agreed on 27 May to suspend the debt ceiling, and Washington's political drama ended in its usual anticlimax. The financial bill is only now arriving. Once both chambers of Congress pass the deal, which they are expected to take up this week, the Treasury can stop its extraordinary accounting measures and start rebuilding its cash balance, which is close to empty. The cost of avoiding default will fall on wholesale funding markets, as the Treasury General Account is refilled in a hurry.

Four months on fumes

The government hit its borrowing limit on 19 January and has spent the months since shuffling money between accounts to keep paying its bills. Extraordinary measures, such as suspending new investments by certain federal employee pension funds, bought time but raised no fresh cash, so every net payment was drawn from the Treasury's own balance. On 26 May Janet Yellen told Congress that the government might be unable to meet all its obligations by 5 June. Net bill issuance was held down for months, and yields on bills maturing around that danger date rose well above those on neighbouring maturities as investors shunned them.

A $600 billion hole to fill

To lift its cash towards the target of $600 billion, Janet Yellen's department must sell a flood of short-dated bills. Taking hundreds of billions of dollars of free cash out of the financial system within a few weeks will test how much prime money market funds and primary dealers can absorb. If buyers pay for the bills by running down their balances at the Federal Reserve's overnight reverse repo facility, the wider monetary shock will be softened. If the money comes out of bank deposits, regional banks will face a second jolt this year.

The accounting behind that choice is simple. The Treasury's account sits on the Fed's balance sheet, so each dollar added to it must come out of another Fed liability: either the reserves that banks hold at the central bank or the money parked at the reverse repo facility. More than $2 trillion sits in that facility, most of it placed by government money market funds, and it earns 5.05 per cent overnight with no credit risk. Those funds will switch into bills only when bill yields beat that rate by enough to justify the move, so the Treasury will have to offer more generous yields at its auctions. The more it pays, the more of the drain falls on the facility and the less on bank reserves.

Two drains at once

The refill will not happen in isolation. The Fed is already shrinking its balance sheet by letting up to $95 billion a month of Treasuries and mortgage-backed securities mature without replacement, a pace it reached last September, and that run-off also comes out of reserves or the reverse repo pool. Banks have spent the spring losing deposits to money market funds, whose assets have climbed to a record above $5 trillion as savers chase yields that bank accounts do not match. Silicon Valley Bank and Signature Bank failed in March, and First Republic was seized and sold on 1 May. The deposit base of mid-sized lenders is the part of the system least able to take another hit.

The closest precedent is the summer of 2019, when the Treasury rebuilt its cash after a debt-ceiling suspension while reserves were already thinner than officials realised. In mid-September a corporate tax date and a large settlement of Treasury securities pulled cash out of the banks on the same day, and overnight repo rates spiked far above the Fed's target. The central bank had to lend into the repo market for the first time since the financial crisis. Reserves are far more plentiful today, and the reverse repo facility gives money funds an obvious pool to draw on, so a repeat is unlikely. The episode still shows that trouble starts when the drain lands on reserves in a system whose true minimum nobody knows.

Who ends up paying

The winners are easy to name. Government money market funds, which have been starved of bills since January, finally get a large supply of the paper they are built to hold, and at higher yields than the reverse repo facility offers. Savers who own those funds will see their returns edge up. The Treasury itself pays for the privilege, since every basis point of extra yield needed to clear its auctions is added to the government's interest bill.

The losers are the institutions that fund themselves in short-term markets. If reserves fall far enough, the rate banks charge each other in repo will drift towards, and possibly above, the 5.15 per cent the Fed pays on reserves, and anyone financing positions overnight will pay more. Mid-sized banks that are already borrowing from the Federal Home Loan Banks and the Fed's emergency facility would find that funding dearer still.

The case for calm

The strongest argument for calm is that the Treasury controls the pace. It can spread its auctions over the summer, lean on longer-dated bills that money funds like, and accept a slower rebuild if funding markets show strain. The Fed's standing repo facility, created in 2021 after the 2019 spike, lets dealers borrow cash against Treasuries at a fixed rate and should cap any jump in overnight rates. Taken together, these make a systemic funding crisis unlikely. They do less for individual banks whose depositors decide that a bill yielding more than 5 per cent is a better home for their cash.

What the weekly data will show

The Fed's balance-sheet release, published every Thursday, will reveal which pool is being emptied. A reverse repo balance that falls roughly in step with the Treasury's rising cash would mean the money funds are doing the lifting. A steady reverse repo balance alongside falling reserves would point to deposits leaving the banks, and would put fresh pressure on lenders already paying up to keep customers. Quarterly corporate tax payments in mid-June will also flow into the Treasury's account, and the Fed's meeting on 13-14 June falls while bill issuance is at its heaviest.

The debt-ceiling farce avoided a technical default. Rebuilding the Treasury's cash will now drain liquidity on top of quantitative tightening over the summer, just as regional banks can least afford to lose more deposits, and the weakest of them will probably be paying noticeably more for their funding by the end of July.