October 9, 2013 9:12 am

Collateral crunch feared as T-bill yields leap

Halloween has taken on a new meaning for US Treasury bills: the threat of a debt default now looms as the ultimate “trick” for financial markets.

The humble short-term Treasury bill occupies a pivotal place in the infrastructure of financial markets. But its “risk free” status is at risk as politicians in Washington squabble over raising the $16.7tn debt ceiling.

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The fight in Congress could leak to the US Treasury delaying a payment on its debt, which would constitute a technical default.

Investors such as Fidelity and other money funds are already voting with their feet. Yields for bills that mature in October and November have risen above 30 basis points – a level not seen since late 2008, when the Federal Reserve adopted a zero interest rate policy during the depths of the financial crisis.

Risk aversion was certainly the mantra on Tuesday, when the Treasury sold new one-month bills at a yield of 35 basis points, a threefold jump from the prior week and just shy of the two-year Treasury yield of 0.38 per cent. Normally investors demand a smaller return for holding shorter-term debt, since they are usually viewed as less risky.

The flight from near-term bills could have major repercussions for key financing markets as Treasury collateral is widely used by central banks, sovereign wealth managers, banks, custodians and other investors for borrowing short-term cash and supporting derivatives positions and other types of trading.

The longer the stand-off in Washington continues, so the risk grows that certain Treasury securities start to be seen as too risky to take as collateral for the short-term loans that underpin this financing, via the vast “repo market”.

“The twists and turns in the debt ceiling stand-off are now finally beginning to make its presence more forcefully felt in the markets,” says Eric Green, global head of rates strategy at TD Securities. “The bills market was the first red flag and that has now extended into a broader repo market as a cash hoarding theme begins to take shape with some transactions even steering clear of using Treasury as collateral.”

The head of rates trading at a major bank told the FT: “There are certain types of collateral [bills maturing in the next month] we do not want.”

In the event of an actual missed payment by the Treasury, all bets are off.

Steven Major, strategist at HSBC, says: “In a payment delay situation, the financial system would be tested and the biggest impacts would be on the repo market and clearing systems that take Treasuries as collateral.”

Chris Probyn, chief economist at State Street Global Advisers, says all kinds of investments could go into free fall, as they did when funding markets dried up in 2008.

“The repo market could then become absolutely inoperable, there would be all kinds of sellers and no kind of buyers. It is a sobering thought,” says Mr Probyn.

While some investors exit bills, others are taking advantage of owning them at sharply higher yields as they expect the debt ceiling will be raised before the US Treasury runs out of cash after October 17.

In the event the debt ceiling is not raised, others contend that the Treasury is likely to prioritise payments or simply extend maturities in order to make sure a technical default does not occur.

“If the US does hit its debt limit and goes into technical default this shouldn’t need to cause financial chaos as long as there continues to be an expectation that missed coupon payments will eventually be repaid within days or, at worst, weeks,” says Jim Reid, strategist at Deutsche Bank.

“The problem comes as the longer we go past the debt limit date and the deeper in arrears the US government gets, the greater the chance of a sudden break in the system.”

Burgeoning disruptions are already evident in a variety of technical financial markets. The yield on one-month T-bills has overtaken the one-month interbank lending rate, known as Libor, for the first time in a dozen years.

The curve in credit default swaps (CDS) on US debt has also inverted – indicating that purchasers of the derivatives are, in theory, pricing in a higher risk of default in the short term than in the longer term.

CDS on US government debt has doubled in the past month and trading volumes have jumped as a growing number of investors have bought the instruments, seeking protection against a potential default or making bets on subtle movements in the derivatives.

Meanwhile, some fear bill yields could rise further as the gridlock continues.

“For now, people will keep selling Treasury bills,” says Robbert van Batenburg, director of market strategy for Newedge. “The US Congress is not going to look at what’s been going on with Treasury bills and take it as a sign that now they have to get really serious. That will only happen once stocks start to collapse.”

But bill yields are already sending an important signal that this year’s Halloween may be remembered in more ways than one.

Mr Probyn says: “If you play with matches in an ammo dump for long enough, something is going to go boom.”

Additional reporting by Vivianne Rodrigues

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