The Treasury bills nobody wants to hold

Treasury bills maturing in April and May yield about 4.0 per cent. Bills maturing in early June, right in the window when the government is expected to hit its "X-date" and run out of cash, yield well above 5.5 per cent. With the debt ceiling heading for a summer showdown, the front end of the Treasury curve has developed a kink of a kind rarely seen before. In repo and cash markets, June paper is the debt nobody wants. Investors are demanding a 150-basis-point premium against default to hold IOUs from the world's most powerful government.

The kink comes from the rules that govern money market funds. Prime and government funds are barred from holding securities that have defaulted or whose payments are delayed.

How the clock started

The federal government reached its statutory borrowing limit of about $31.4 trillion on 19 January. Since then the Treasury has kept paying its bills by using extraordinary measures, accounting manoeuvres such as suspending investments in certain federal employee pension funds, and by drawing down the cash in its account at the Federal Reserve. Janet Yellen told Congress in January that those measures were unlikely to run out before early June. The Congressional Budget Office said in February that the money would probably last until some point between July and September.

The gap between those estimates is the reason June paper trades so oddly. The exact date depends on how much tax the Treasury collects this month, since April receipts are the largest of the year and their size is hard to forecast. Strong receipts would push the X-date into the summer; weak ones would pull it into the first days of June. Until the numbers are in, investors are pricing the worst case.

What a missed payment would mean

If the Treasury reaches the X-date without permission from Congress to borrow, it will have to delay principal or interest payments on maturing debt. For a cash manager, holding a bill that pays even forty-eight hours late would be an operational disaster, bringing audit freezes and write-downs, and very likely a rush of client redemptions. To avoid that risk, managers are dumping June bills wholesale and accepting lower yields on May paper just to be sure of getting their money back before the cash runs out.

Contingency plans drawn up by the Fed and market groups during earlier standoffs assumed that the Treasury would extend the maturity of affected securities one day at a time, so that they could still be traded and settled through the Fed's payment system. That would keep the plumbing working. It would not stop a money fund's lawyers from classifying a late bill as a problem asset, which is the risk the funds are paying to avoid.

Collateral nobody will take

That is gumming up the repo market. Central clearing houses and cautious corporate treasurers are refusing to accept June bills as collateral.

Dealers will hold the paper only with steep haircuts on their balance sheets, which drains still more liquidity from the front end. The effect runs through the whole chain of short-term finance, since Treasury bills are the collateral against which dealers borrow cash overnight. A security that some lenders will not accept is worth less to every holder, whatever its credit quality.

The supply of bills adds to the distortion. Under the debt limit the Treasury cannot increase its total borrowing, so it has been shrinking its stock of bills to make room for other obligations. Fewer bills maturing in April and May, combined with more demand for them, pushes their yields below where the Fed's policy rate would normally put them. June paper, meanwhile, is left to buyers willing to take the risk, who demand compensation.

What earlier standoffs showed

America has come close before. In 2011 Congress raised the ceiling only days before the Treasury's estimated deadline, and Standard & Poor's cut the country's credit rating below AAA shortly afterwards. In October 2013 yields on bills maturing just after that year's deadline jumped in much the same way as June bills today, and fell back as soon as a deal was signed. The one time the Treasury actually paid late, in 1979, the cause was a paperwork breakdown during a debt-limit squeeze rather than a political choice, and the holders affected were small investors who had to wait for their money.

These episodes suggest the kink is a temporary price for an operational risk. They also suggest that the government has always found a way to pay at the last moment. Investors who bought bills near the deadline in 2011 and 2013 were repaid in full, and collected an extra yield for their nerve.

Who gains from the kink

The winners are investors who are not bound by money fund rules and can hold June bills to maturity, such as some hedge funds and foreign official holders with long horizons. They collect a yield well above the Fed's policy rate for a security that is overwhelmingly likely to pay. The Treasury is a loser, since it pays more to borrow over those weeks, and so are money funds, which give up yield to avoid a small risk. Corporate treasurers who cannot use June bills as collateral face slightly higher costs in their short-term funding.

The case against complacency is that the politics look harder than in 2013. House Republicans want spending cuts in return for raising the limit, and the White House insists on an increase without conditions. A late deal is the most likely outcome, but a genuinely missed payment is no longer unthinkable, and even a brief delay would do lasting damage to the status of Treasury bills as the world's safest cash substitute.

The signals to watch are the tax receipts reported in the Treasury's daily statement over the rest of April, any updated estimate of the X-date from Yellen, and whether Congressional leaders begin talks. The spike in June bill yields says little about America's creditworthiness. It reflects fund managers who cannot risk even a short payment delay, and the kink is likely to last until Congress acts, probably not before late May.