Do You Remember What Happened The Last Time The US Debt Limit Was Suspended?

Clue - It begins with a 'Co' and ends with a 'vid'

Photo by Alexander Grey on Unsplash

Before I start, let me explain two concepts for those that are new to the subject - US Debt Limit Suspension & The Repo Market.

1. U.S. Debt Limit Suspension: The U.S. debt limit, also known as the debt ceiling, is the total amount of money that the United States government is authorised to borrow to meet its existing legal obligations. This includes Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments. The debt limit does not authorise new spending commitments; it simply allows the government to finance existing legal obligations that Congress and presidents of both parties have made in the past.

2. The Repo Market: A repo, or repurchase agreement, is short-term borrowing for dealers in government securities. The dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day. Repos are typically used to raise short-term capital but are also used by the Federal Reserve to conduct monetary policy.

Over the last few days, details of a US debt ceiling deal have hit the headlines. At the weekend, Joe Biden and House speaker, Kevin McCarthy, agreed to suspend the debt limit. In its place will be an unlimited debt ‘ceiling’ until January 2025. So no ceiling then.

The debt limit was last suspended in August 2019, allowing the U.S. government to borrow an unlimited amount until a specified date. A month later, in September 2019, the "repo crisis" occurred. It was characterised by a sudden spike in the overnight lending rate in the repo market, which jumped to nearly 10% from the usual band of around 2%.

So, how was the suspension of the U.S. debt limit in August 2019 connected to the repo market crisis a month later?

When the U.S. debt ceiling was suspended, the Treasury started issuing more bonds to rebuild its cash balance which had run down while the debt ceiling was in place. This caused an increase in the supply of bonds in the market.

The market for Treasury bonds is closely linked to the repo market because Treasury bonds are often used as the collateral for repo transactions. With more bonds in circulation due to the increased issuance by the Treasury, more cash was needed in the repo market to buy these bonds. This put pressure on the amount of cash available for lending in the repo market.

At the same time, other factors were also at play. In particular, a large amount of corporate tax payments were due in mid-September, which further drained the banking system's reserves because taxes are paid with bank deposits that ultimately come out of the reserves banks hold at the Fed.

The combination of these factors caused a cash crunch in the repo market, leading to a spike in the overnight lending rate as demand for cash outstripped supply. This signalled a liquidity crisis, which the Federal Reserve had to step in to alleviate by offering repo operations to inject cash into the system.

We all know what happened next. Within a few months a global pandemic had hit and policies incredibly similar to those in BlackRock’s white paper - ‘Dealing with the next downturn. From unconventional monetary policy to unprecedented policy coordination’ - were implemented. This white paper had been drafted the same month that the U.S debt ceiling limit had been suspended in August 2019.

So with the latest debt ceiling deal, will the same thing happen?

Already, Goldman Sachs has warned that ‘as debt limit talks intensify, the US may have to quickly raise $1 trillion’. They say this will result in liquidity draining from the market, as it did in 2019.

Last time the debt ceiling limit was raised, the repo crisis occurred. Many speculate that the Covid crisis was used as cover for this financial crisis. At the very least, the pandemic was used to facilitate policies that allowed the financial crisis to remain hidden.

What will happen if the latest debt ceiling limit deal is passed?