The United States narrowly avoided a default when President Biden signed legislation on Saturday allowing the Treasury Department, which was dangerously close to running out of cash, to borrow more to pay the country’s bills .
Now the Treasury is beginning to build up its reserves, and the upcoming borrowing could lead to complications that rock the economy.
According to estimates by several banks, the government is expected to borrow around $1 trillion by the end of September. This steady borrowing will result in cash flowing from banks and other lenders into government bonds, draining money from the financial system and increasing pressure on already struggling regional lenders.
In order to entice investors to lend the government such large sums, the Treasury must expect rising interest costs. Given how many other financial assets are tied to the Treasury rate, higher borrowing costs for the government also increase costs for banks, corporations and other borrowers, and could have a similar effect as federal rate hikes by about a quarter point or two in reserve , analysts warn.
“The main cause is still the whole debt ceiling standoff,” said Gennadiy Goldberg, interest rate strategist at TD Securities.
Some policymakers have indicated they may decide to pause from raising rates at next week’s central bank meeting to assess how the policies have affected the economy so far. Restoring the Treasury’s liquidity could undo that decision, as it would inevitably raise borrowing costs.
This, in turn, could add to concerns that surfaced in the spring among investors and depositors that higher interest rates have depreciated the value of small and medium-sized banks’ assets.
The flood of sovereign debt is also amplifying the impact of another Fed priority: shrinking its balance sheet. The Fed has reduced the amount of new Treasury and other debt it buys, by phasing out old debt and already leaving more debt for retail investors to digest.
“The potential hit to the economy if the Treasury Department goes on the market and sells that much debt could be extraordinary,” said Christopher Campbell, who served as deputy treasury secretary for financial institutions from 2017-2018. “It’s hard to imagine the Treasury Department going out and selling something.” It could be $1 trillion worth of bonds with no impact on borrowing costs.”
Cash on hand in the Treasury Department’s general account fell below $40 billion last week as lawmakers scramble to reach an agreement to raise the country’s borrowing limit. Mr. Biden signed legislation on Saturday that suspended the $31.4 trillion debt ceiling until January 2025.
Treasury Secretary Janet L. Yellen used accounting maneuvers, known as extraordinary measures, for months to delay a default. This included suspending new investments in pension funds for postal workers and civil servants.
Recovering these investments is essentially a simple accounting fix, but replenishing government coffers is more complicated. The Treasury Department said on Wednesday it hopes to borrow enough by the end of June to replenish its cash account to $425 billion. In order to be able to cover the planned expenditure, the country would have to borrow far more, said analysts.
“The floodgates are open now,” said Mark Cabana, interest rate strategist at Bank of America.
A Treasury spokesman said the ministry carefully considered investor demand and market capacity when making decisions about debt issuance. In April, Treasury Department officials began polling key market participants on how much they think the market could absorb after the debt ceiling standoff was resolved. The Federal Reserve Bank of New York this month asked major banks for their estimates of what they think will happen to bank reserves and borrowing on certain Fed facilities over the next few months.
The spokesman added that the department has dealt with similar situations before. Notably, after a 2019 debt ceiling row, the Treasury replenished its cash stash over the summer, contributing to factors that have drained reserves from the banking system and turned the market’s system on its head, prompting the Fed prompted to intervene to avert worse crisis.
Among other things, the Fed has introduced a program for repurchase agreements, a form of financing in which government bonds are pledged as collateral. This backstop could provide a safety net for banks that are short of cash from lending to the government, although its use has been widely seen in the industry as a last resort.
A similar but opposite program, in which Treasury securities are issued in exchange for cash, now holds over $2 trillion, mostly from money market funds that have struggled to find attractive, safe investments. Some analysts see this as money on the table that could flow into the Treasury account as it offers more attractive interest rates on its debt, thus reducing the impact of borrowing.
But the mechanism by which the government sells its debt, charging 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 could find themselves short on cash, while investors and others may be reluctant to lend to institutions they believe are struggling given recent concerns about some areas of the industry.
This could leave some banks dependent on another Fed facility, set up at the height of this year’s banking turmoil, to provide emergency funding to deposit-taking institutions at a relatively high cost.
“One or two or three banks could be caught unprepared and suffer the consequences, creating a chain of fears that can permeate the system and cause problems,” said Mr. Goldberg of TD Securities.