The debt ceiling rises by $5trn

The President has signed the Omnibus Budget and Balanced Border Act (OBBBA), raising the statutory federal debt ceiling by $5 trillion and ending months of political brinkmanship. Money markets get little relief from it. The Treasury must now rebuild its Treasury General Account (TGA), and that will pull cash out of short-term funding markets.

The limit had been binding since the start of the year, when the ceiling that had been suspended in 2023 was reinstated at its new level and the Treasury began using extraordinary measures to keep paying its bills. Those measures, such as suspending investments in certain federal employee pension funds, buy time but do not raise cash. As they were used up, the Treasury ran down its account at the Fed to cover the gap between spending and receipts.

Refilling the Treasury's account

The Treasury's cash balance has been run down to emergency operating levels. To get it back towards the $850 billion target, the department must sell a large net volume of bills in the space of a few weeks. Little cash is left in the Fed's overnight reverse repo facility to absorb them. So every dollar of new bills has to be paid for out of the reserves that commercial banks hold at the central bank.

The plumbing works like this. When a money-market fund or a bank buys a newly issued bill, cash moves from the buyer's account into the Treasury's account at the Fed. The Treasury's account sits outside the banking system, so money deposited there disappears from the pool of reserves banks use to settle payments and meet regulatory requirements. If the buyer is a money fund that had parked its cash at the Fed's reverse repo facility, the drain falls on that idle cash instead. If it is a bank, or a fund whose cash was lent into private repo, the drain falls on reserves.

Why 2023 was easier

The last rebuild offers a contrast. After the ceiling was suspended in June 2023, the Treasury sold a flood of bills to restore its cash balance, and many market participants expected a squeeze on reserves. It never came, because money-market funds pulled hundreds of billions of dollars out of the Fed's reverse repo facility to buy the higher-yielding bills. The facility acted as a buffer, and bank reserves barely fell.

That buffer is now much thinner. Balances at the reverse repo facility have shrunk steadily over the past two years as the Fed's balance-sheet reduction and heavy bill issuance drew them down. The next few hundred billion dollars of new bills will therefore have to be financed more directly out of bank reserves, which is exactly the part of the system where shortages show up as spikes in funding rates.

Repo rates under pressure

Draining liquidity this fast causes trouble in short-term funding. Tri-party repo rates and the Secured Overnight Financing Rate (SOFR) will probably be pushed higher as primary dealers struggle to carry the flood of new paper on their books.

Dealers sit at the centre of the strain. They buy bills at auction and finance them in the repo market until they can sell them on, and their capacity to do so is limited by leverage rules that count Treasuries against their balance sheets. When supply arrives faster than end-investors take it, dealers bid up repo rates to fund their inventory, and the pressure spreads to everyone who borrows overnight against Treasury collateral.

The memory of September 2019

The warning case is September 2019. A corporate tax deadline and the settlement of a large Treasury auction drained reserves on the same day, and overnight repo rates jumped far above the Fed's target range. The Fed had to inject cash through emergency repo operations and later began buying bills to rebuild reserves. Officials concluded that reserves had fallen below the level the banking system needed, a level no one had known precisely in advance.

The Fed has more tools now. Its standing repo facility, created in 2021, lets eligible banks and dealers borrow overnight against Treasuries at a set rate, which should cap any spike. It has also slowed the pace at which it shrinks its holdings of Treasuries. Those tools limit how far rates can jump, but banks have been reluctant to use the standing facility for fear of the stigma, so the cap is softer than it looks on paper.

Who feels the squeeze

The first to feel it will be leveraged investors who fund bond positions overnight, including hedge funds running basis trades between Treasury futures and cash bonds. Their financing costs rise with repo rates, and a sharp move can force them to unwind positions quickly. Money-market funds, by contrast, gain, since they earn higher yields on bills and repo. Corporate borrowers who rely on commercial paper may pay a little more as bill supply competes for the same investors.

The strongest case for calm is that the Fed can see this coming and has said it will adjust the pace of its balance-sheet reduction if reserves approach scarcity. Most estimates put reserves still comfortably above the danger zone. That is probably right for the system as a whole. The problems in 2019 appeared first at particular dates and in particular institutions, not in the averages.

What to watch

The indicators are the size of weekly bill auctions, the daily balance at the reverse repo facility, the gap between SOFR and the interest rate the Fed pays on reserves, and any use of the standing repo facility around month- and quarter-ends. Raising the ceiling removes the risk of a technical default and swaps it for a mechanical drain on liquidity. Over the next few weeks money-market conditions will tighten, and they will do so just as corporate credit spreads sit near their cyclical tights. The likeliest outcome is a series of short-lived spikes in repo rates around settlement dates rather than a 2019-style seizure, but those spikes will fall hardest on leveraged funds and could push the Fed to end its balance-sheet reduction sooner than it planned.