Wall Street hardly stirred this week amid the latest debt ceiling drama, reflecting both investor fatigue with how lawmakers handle the public purse and confidence in a financial system armored with cash.
Only in the market for short-term government securities were there signs of angst, as investors fled Treasury bills scheduled for repayment around Oct. 18, which is the date when Treasury Secretary Janet L. Yellen had said that she expected the federal government to run out of cash.
Trading in these “red zone” securities returned to normal on Thursday after Senate leaders, vindicating the confidence on Wall Street, agreed on a deal to postpone the debt limit showdown to December. The measure passed the Senate Thursday night, and the House plans a Tuesday vote.
“The market’s not going to react to all the political drama. We’ve just seen this movie too many times,” said Priya Misra, head of global rates strategy for TD Securities in New York, speaking before the deal emerged.
Stoicism in the financial markets was born of experience. Two previous showdowns over raising the government’s borrowing limit, in 2011 and 2013, rattled investor nerves but ultimately fizzled short of default.
Even Standard & Poor’s unprecedented downgrade in 2011 of the “AAA” credit rating of the U.S. government, which analysts feared would ignite a financial contagion, passed without mishap. Government borrowing costs actually fell in the aftermath, confounding the doomsayers.
However scary it was at the time, those episodes handed market players greater confidence that they could weather a genuine crisis if the federal government had to delay repaying investors for a day or two.
“We have been through this song and dance multiple times,” said Blake Gwinn, head of U.S. rates strategy at RBC Capital Markets, who worked for the Federal Reserve Bank of New York during earlier debt battles.
The Securities Industry and Financial Markets Association (SIFMA) developed procedures for trading securities if the government halted investor repayments, while the Treasury Market Practices Group, with members from firms like BlackRock and JPMorgan Chase, drafted its manual for keeping the $22 trillion Treasury market functioning.
Despite Treasury denials, bond traders expect the government to prioritize repaying bondholders under a plan shaped in the 2011 debt crisis.
“Principal and interest payments on Treasury securities would continue to be made on time,” Susan Foley, a senior associate director at the Federal Reserve, told members of the central bank’s policymaking committee in a 2013 conference call. To afford to do that, “the Treasury may need to delay or hold back making other government payments,” she added.
Such a prioritization of payments, which could lead to Chinese bondholders being paid before Social Security recipients, would “likely undermine” the U.S. credit rating, Fitch Ratings said last week. If Washington had failed to raise the debt ceiling — which currently caps the federal debt at more than $28 trillion — the Treasury Department would legally be unable to spend money beyond what the U.S. government collects in taxes.
The fate of Treasury securities is considered crucial to the global economy because they are the risk-free investment that serves as the foundation for all financial markets. Investors decide what stocks and corporate bonds are worth, relative to the return offered by Treasury securities.
The U.S. government bonds also are often used as collateral in the routine overnight borrowing which financial institutions and many corporations perform to keep the economic gears turning in the country.
If the fundamental value of Treasury securities is shaken, the aftershocks will reach the retirement accounts and jobs of Americans, and will affect the value of the dollar and government borrowing costs. “You’re running the risk of doing long-term damage,” Misra added. “If you question the risk-free asset, then you have to question every other asset.”
To be sure, some market watchers — alarmed by rising polarization and dysfunction in Washington — warned that Congress this time could topple into the financial abyss. Just hours before Senate Minority Leader Mitch McConnell (R-Ky.) offered Democrats an escape, Goldman Sachs told clients, “There is a real risk that Congress will miss the deadline.”
Wall Street analysts anticipated that market tremors would worsen in the days before Oct. 18. Morgan Stanley analysts had warned that next week, Treasury bills would “probably start cheapening up, and quickly.” Those who forecast a compromise, however, said the drama was overstated. Even in the worst case, a “technical default” measured in days would be nothing like the debt defaults of countries such as Greece or Argentina.
“It’s not like somebody who owns the T-bills isn’t going to get paid. They’ll get it back a week later,” said Peter Boockvar, the chief investment officer of the Bleakley Advisory Group. “For markets, it’s a nonevent.”
Investor reactions played a role in driving a resolution during earlier debt ceiling showdowns. In 2011, the nation was struggling to emerge from the wreckage of the housing bubble when Republicans demanded austerity as a cure for the federal budget deficit. The unemployment rate was 9 percent and the economy had contracted in the most recent quarter as the United States hit the debt ceiling and Treasury Secretary Timothy Geithner at the time ordered the use of extraordinary cash-conservation measures.
Consumer confidence, which had been rising, quickly reversed course and fell for the next three months, reaching its lowest point since the depths of the 2008 financial crisis. Likewise, the National Federation of Independent Business optimism gauge sank to its lowest point in nearly 18 months.
As the crisis peaked in late July, the Dow fell nearly 16 percent in just 13 trading days. Yet when Standard & Poor’s issued the first-ever downgrade of the U.S. credit rating, the market reaction was not what investors had feared. On Aug. 5, following the budget-cutting deal that ended the faceoff between President Obama and Republican leaders in Congress, the credit rating agency blasted the evident fiscal management by policymakers in Washington as “less stable, less effective and less predictable.”
Such criticism should have discouraged investors from lending money to the government. But spooked by the unfamiliar financial landscape, they flocked to the perceived safety of Treasury securities, driving the yield on the 10-year bond to below 2.1 percent from more than 2.5 percent. The market response was less distinct in the 2013 debt limit fight.
As Yellen’s current Oct. 18 deadline, dubbed the X-date, drew near, the president and his team grew outspoken about the fiscal danger. Biden on Wednesday accused Republicans of playing “Russian roulette” with the U.S. economy while his advisers warned of a crisis that could be “even worse” than in 2008. He called business leaders to the White House to make the case for avoiding a default by the federal government.
“Day one would be bad, but the cascading effects in the ensuing weeks could go anywhere from a recession to a complete catastrophe for the global economy. And I don’t know why anyone would take a chance like that,” said Jamie Dimon, the chief executive of JPMorgan.
The faith shown by Wall Street had a happy ending this week that rested on a cushion of cash and on guardrails which the Federal Reserve put in place last year, following unusual activity in the Treasury market.
As the economy began shutting down in March 2020, investors staged a “dash for cash,” selling large amounts of Treasury bonds to raise money. The yield or interest rate the government had to pay to attract investors spiked and buyers grew scarce. Later that month, the Fed announced it would buy Treasury bonds without limit to bolster the market.
This July, the Fed established a $500 billion standing repurchase facility, which allows banks to use Treasury securities as collateral for overnight loans, and made permanent a similar program for foreign central banks, which had been launched as a temporary measure. This eased Wall Street worries about what would happen if a default upended the market.
Last month, the Fed eased limits on an older program, called the overnight reverse repo facility, which provides a safe parking place for short-term funds. In both 2011 and 2013, money market mutual funds — one of the biggest buyers of the Treasury securities that have wobbled in recent days — saw significant outflows as investors fled a feared federal default.
In just three weeks during the 2011 standoff, investors pulled $64 billion from the money market mutual funds, which are designed to be ultra safe and thus are allergic to losses. Such a financial exodus can push mutual fund managers into forced selling, aggravating any market declines.
This year, that selling did not materialize because the funds have been able to put their cash into Fed facilities rather than chase after Treasury bonds. Those have been in short supply as Treasury approached the government borrowing limit. Mutual funds funneled almost $400 billion into the Fed facility since September, driving the total to more than $1.45 trillion.
“Absolutely, it does help address the tail risk of something breaking in the financial system,” said Ajay Rajadhyaksha, a managing director who heads macroeconomic research for Barclays. “The support facilities do make it less problematic from a financial system standpoint,” he said.