Divyang Shah
IFR Senior Strategist
The S&P 500 is trading just under 1,700 and the VIX index still below 20% highlight the degree to which markets are still willing to bet on a resolution to the US debt ceiling impasse. The real impact of debt ceiling worries, however, can be seen in the inverted Treasury bill curve, and policy makers’ concerns rest on how this will impact on the repo market, which is integral to the funding of all banks.
A look at equities and the VIX would suggest there is little unease over the debt ceiling. The stress, however, will not be evident in these risk markets, which seem to be relying instead on the prospect of continued central bank liquidity support. If anything, risk markets are being buoyed by the potential for a delay to Fed tapering the longer the debt limit risks persist.
Whether this is complacency or simply looking at the bigger picture remains to be seen, but those involved in the repo market are certainly not taking any chances.
Repos are key for bank funding, and the signals here are worth keeping an eye on, especially given the lessons learned during and after the Lehman crisis, when the once boring and unsexy money markets became a key source of stress and a focal point for the market and policy makers. Now, as a precautionary measure and to avoid the risks of having funds tied up due to potentially delayed payments from the Treasury, some players have sold their bill holdings while others have made plans to exclude some bills from eligible repo collateral.
Before the focus on a six-week extension surfaced, the Treasury bills affected tended to be those maturing in October – specifically Oct 17 – but now yields have moved higher across the curve. This is purely on concerns over liquidity as opposed to not being paid, but when you start to factor in a risk premium such as this on safe assets, there will be repercussions for other assets. If there is no debt ceiling agreement and payment is delayed, then the Fed will need to gauge the wider economic implications beyond the shutdown/debt ceiling impact on sentiment.
While the Fed can do little about delayed payments on specific bills, it will attempt to keep the repo market functioning by promising to provide liquidity and rely on dollar swap lines. While easier collateral rules are also likely, an alternative would be to:
1) conduct operation twist that involves swapping its portfolio of Treasury bonds for Treasury bills, and/or
2) be willing to swap bills for Fed paper which can be used for repos instead.
The tail risks and unintended consequences stemming from the US repo market mean that other CBs will also have done their homework and have contingency plans in place.