A debt overhang of $1 trillion lurks behind the debt ceiling

The United States narrowly avoided a default when President Biden signed legislation on Saturday that allowed the Treasury Department, which was dangerously close to running out of cash, to borrow more money to pay the nation’s bills.

Now the Treasury is starting to build up its reserves, and the upcoming borrowing binge may present complications that will devastate the economy.

The government is expected to borrow around $1 trillion by the end of September, according to estimates from several banks. The stable credit situation is set to draw cash from banks and other lenders into government securities, draining money from the financial system and intensifying pressure on already stressed regional lenders.

To entice investors to lend such huge sums to the government, the Treasury faces increasing interest costs. Given how many other financial assets are tied to Treasury yields, higher borrowing costs for the government also raise costs for banks, corporations and other borrowers, and could create a similar effect to roughly one or two quarter-point interest rate hikes by the Federal Reserve, analysts have warned.

“The root cause is still very much the entire debt ceiling,” said Gennadiy Goldberg, a fixed income strategist at TD Securities.

Some policymakers have indicated they may choose to take a break from raising interest rates when the central bank meets next week, to assess how policy has so far affected the economy. Treasury’s cash rebuilding could undermine that decision, because it would push borrowing costs higher anyway.

This could in turn heighten concerns among investors and depositors who flared up this spring over how higher interest rates had eroded the value of assets in small and medium-sized banks.

The deluge of sovereign debt also amplifies the effect of another Fed priority: the shrinking of the balance sheet. The Fed has reduced the number of new Treasuries and other debt it buys, slowly letting old debt roll-off and already leaving private investors with more debt to digest.

“The potential blow to the economy when the Treasury goes to the market and sells this much debt could be extraordinary,” said Christopher Campbell, who served as assistant secretary of the treasury for financial institutions from 2017 to 2018. “It’s hard to imagine the Treasury going out and sell what could be $1 trillion of bonds and not have an impact on borrowing costs.”

The cash balance in the Treasury’s general account fell below $40 billion last week as lawmakers raced to agree on raising the nation’s borrowing limit. Mr. Biden signed legislation on Saturday that suspended the $31.4 trillion debt limit until January 2025.

For months, Treasury Secretary Janet L. Yellen had used accounting maneuvers known as extraordinary measures to delay a default. They included the suspension of new investments in pension funds for postal workers and civil servants.

Restoring these investments is essentially a simple accounting solution, but replenishing the government’s cash is more complicated. The Treasury Department said Wednesday it hoped to borrow enough to rebuild its cash account to $425 billion by the end of June. It will need to borrow much more than that to take into account planned spending, analysts said.

“The supply floodgates are now open,” said Mark Cabana, a fixed income strategist at Bank of America.

A Treasury spokesman said that when making decisions to issue debt, the department carefully considered investor demand and market capacity. In April, the financial authorities began surveying key market players about how much they thought the market could absorb after the debt limit was resolved. The Federal Reserve Bank of New York this month asked major banks for their estimates of what they expected to happen to bank reserves and borrowing from certain Fed facilities over the next few months.

The spokesman added that the department had managed similar situations in the past. In particular, after a row over debt limits in 2019, the Treasury rebuilt its cash pile over the summer, adding to factors that drained reserves from the banking system and changed the market’s plumbing, prompting the Fed to intervene to avert a worse one. crisis.

One of the things the Fed did was establish a program of repurchase agreements, a form of financing backed by government debt. That backstop could provide a safety net for banks short of money from lending to the government, although its use was seen in the industry as a last resort.

A similar but opposite program, which distributes government securities in exchange for cash, now has over $2 trillion, mostly from money market funds that have struggled to find attractive, safe investments. This is seen by some analysts as money on the sidelines that could flow into the Treasury’s account as it offers more attractive interest rates on the debt, reducing the impact of the borrowing spree.

But the mechanism by which the government sells its debt, debiting bank reserves held at the Fed in exchange for the new bills and bonds, could still test the resilience of some smaller institutions. As their reserves dwindle, some banks may find themselves short of cash, while investors and others may be unwilling to lend to institutions they see as troubled, given recent concerns about some corners of the industry.

That could leave some banks dependent on another Fed facility, set up at the height of this year’s banking crisis, to provide emergency funding to deposit-taking institutions at relatively high costs.

“You could see one or two or three banks being caught off guard and suffering the consequences, starting a cascade of fears that could permeate the system and create problems,” said Goldberg of TD Securities.

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