Since World War II, the U.S. debt ceiling has been adjusted—either raised or suspended—more than a hundred times, with the Treasury never having depleted its cash reserves and borrowing capacity before Congressional intervention. We remain confident that the debt limit will be increased in a timely manner.

As we navigate the complexities of the U.S. debt ceiling, investors should understand the potential impacts on money market investments. The debt limit, commonly referred to as the debt ceiling, represents the maximum amount of debt that the U.S. Department of the Treasury can issue to the public or other federal agencies. The Fiscal Responsibility Act of 2023 had suspended the statutory debt limit through January 1, 2025, with a new limit taking effect on January 2, 2025. As of this date, the Treasury is unable to issue additional debt that exceeds this limit, although it can continue to roll over existing debt as it matures.

To manage its obligations, the Treasury can employ extraordinary measures and utilize cash reserves to delay the point at which it cannot finance existing commitments. These extraordinary measures include reclassifying certain debt to create additional borrowing room. The "X-date," or the date when the Treasury will no longer be able to meet all of its obligations, is currently projected between August and September. However, this estimate is subject to change as we approach that period. The Congressional Budget Office (CBO) now estimates that the government’s ability to borrow would probably be exhausted between mid-August and the end of September 2025. Treasury Secretary Bessent estimates that the government could run out of cash in August.

In the unlikely event of a technical default, we anticipate that the Treasury would prioritize servicing the principal and interest on U.S. Treasury Bills and Notes over other domestic commitments, such as federal salaries and Social Security payments. This prioritization would support the issuance of new Bills and Notes, enabling the redemption of maturing securities and ensuring timely interest payments. Overall, we consider a technical default to be a brief and highly improbable event, not aligned with our primary expectations.

On the legislative front, the process of raising or re-suspending the debt limit has historically been slow and fraught with challenges. Despite Republican majorities, the narrow margins in Congress continue to complicate efforts to address the debt ceiling. Congressional leaders are actively working on budget plans to raise the debt limit, with the Senate aiming to vote on a marked-up version of the House-passed reconciliation bill before July 4th. This bill can pass with a simple majority in the Senate, thereby avoiding a filibuster. However, if the marked-up bill is passed, further negotiation is needed with the House. A critical factor in the legislative timeline is the congressional recess, which spans nearly the entirety of August. This recess may serve as motivation for Congress to resolve the debt limit issue before the break. It's important to note that the "X-date" remains projected between August and the end of September. This timeline does not allow Congress the luxury of delaying the passage of the bill until after they return from recess in September, underscoring the urgency of addressing the debt limit before the recess begins.

In the current market, we've observed a notable cheapening of August T-bill maturities, largely driven by concerns surrounding the debt limit. This trend is particularly pronounced in mid-August T-bills, with each auction revealing the market's general level of avoidance. In a scenario where expectations for Fed rate cuts are nonexistent, one would expect these intra-Fed meeting bills to trade close to the Fed’s target lower bound of 4.25% money market yield (mmy). However, recent auction results have deviated from this expectation, with the last two 1-month and 2-month T-bill auctions showing significant spreads. Two weeks ago, the 2-month auction stopped at 4.41% mmy, while the 1-month stopped at 4.09% mmy. This past week's auctions further highlighted this discrepancy, with the 2-month and 1-month T-bills stopping at 4.50% mmy and 4.07% mmy, respectively. Typically, one would expect these auctions to stop within a few basis points of each other, not with the substantial spreads of 32 basis points and 43 basis points observed.

Significant cheapening in 'at-risk' maturities typically occurs about 30 days before the maturity date, as the 'X-date' window becomes more defined. However, as seen in past debt limit episodes, early cheapening of when-issued bills maturing inside the X-date window is not uncommon. We anticipate that all auctions stopping within the X-date window will continue to trade wide compared to surrounding dates not viewed as at risk. The reason for this cheapening is primarily due to the avoidance strategy employed by money market funds, including our own. As the largest buyers of Treasury bills, when money market funds step away, the normal buyer base shrinks significantly, leading to rate cheapening across all T-bill maturities, particularly during auctions, once a debt limit X-date is more clearly defined.

As the potential “X-date” approaches, we will continue to closely monitor the timeline and fund exposures, refining our strategies as more information becomes available. This includes actively managing exposure to Bills and Notes within the at-risk period, potentially avoiding them and/or diversifying across CUSIPs to mitigate risk. Funds that utilize repo have enhanced flexibility, allowing for more agile adjustments around at-risk dates. In contrast and like we mentioned before, funds that primarily purchase Treasuries, necessitate careful positioning and tactical adjustments to optimize portfolio performance and manage risk effectively. However, our extensive experience and proven track record in successfully navigating past scenarios provide us with the confidence and expertise needed to adeptly manage these situations once again.

Staying informed and proactive in managing your investments is key during these uncertain times. We are committed to providing you with the insights and strategies needed to navigate the evolving landscape.

FAQs

Could Money Market Funds (MMF) hold defaulted US Treasury (UST) securities? Neither Rule 2a-7 nor any of the AAA MMF ratings criteria explicitly require immediate liquidation upon default, nor would holding a defaulted UST lead to a downgrade of the fund’s AAA ratings in isolation.

Are defaulted UST securities liquid? If the Treasury announces its intention to postpone a payment date in advance (the day before the payment is due), the security will remain in Fedwire, and would therefore still be transferable.

What about repo collateral and USTs in default? Defaulted USTs would remain eligible as collateral if maturity dates were extended in a timely manner and the bonds remained on Fedwire. Collateral is re-priced daily so counterparties would be required to “top-up” collateral baskets with additional bonds to maintain required haircuts (assuming price declines on the effected securities).

Would the Fund have adequate liquidity to meet redemption requests from investors in a default scenario? Money market funds maintain a diverse portfolio of liquid assets as a function of regulatory liquidity requirements, including natural liquidity sources such as overnight repos, which can be utilized in the event of a default. The diversification across various maturity dates and instrument types further enhances liquidity, as a UST technical default would likely impact only a specific maturity and instrument type.

Could a Stable NAV/CNAV Fund “break-the-buck” in the event of a default? The fund's 'shadow' Net Asset Value (NAV), or mark-to-market NAV, would need to decline by more than one-half of one percent (0.50%) to approach a 'break the buck' scenario, which is extremely unlikely. Historically, previous debt limit episodes have not led to significant declines in the shadow NAV. Any impacts were limited to a select few positions and did not affect the entire treasury bill curve. Throughout these events, the fund's overall stability and liquidity have been effectively maintained.

What if there was no market (or a very thin/dislocated market) for a defaulted U.S. Treasury security held by the Fund? How would the shadow NAV be impacted? The Fund’s valuation procedures allow for the use of “fair valuation” methodologies in certain situations, particularly when market quotations are not reliable or readily available or if other circumstances exist that warrant the establishment of an internal fair value. With a U.S. Treasury default being technical in nature (and not a solvency issue) we would expect the Fund to consider using its fair valuation tools.

Does JPM GL have a playbook for a default scenario? A detailed playbook has been developed at the AM level to plan for various debt limit scenarios including the specific impacts to GL. This framework has been in place for years given the recurring nature of the debt ceiling issue.

Does the debt ceiling impact government agencies or the Fed RRP programs? Government-Sponsored Enterprises (GSEs) and the Federal Reserve are not directly subject to the federal debt limit. GSEs, like Federal Home Loan Bank, Fannie Mae and Freddie Mac, and the Federal Reserve's operations, including the Reverse Repurchase Agreement (RRP) programs, are not constrained by the debt ceiling in terms of their ability to meet obligations.

In a technical default scenario, would Treasury prioritize payments to meet interest and principal obligations on USTs? In 2023, then treasury secretary Janet Yellen, publicly pushed back on prioritization, stating that the UST’s systems were built to pay all bills on time and not prioritize one payment over another. However, we know that the topic has been discussed at both the Fed and the Treasury and it seems likely that prioritization would at least be considered in the event the debt limit is breached.

• In 2011, during the debt ceiling crisis, the U.S. Treasury considered contingency plans to prioritize payments to bondholders, potentially delaying other government payments to reduce the risk of a technical default. These principles were reiterated during the 2013 debt ceiling discussions.

Conclusion

As the U.S. approaches the projected "X-date," the complexities surrounding the debt ceiling continue to pose challenges for investors and policymakers alike. The potential for a technical default, while considered unlikely, necessitates proactive strategies and careful management of money market fund exposures. Legislative efforts to address the debt ceiling are ongoing, with critical votes expected before the August recess. Money market funds remain committed to maintaining liquidity and stability, leveraging their experience and strategies to navigate the evolving landscape. Staying informed and adaptable is crucial for investors during these uncertain times, as the situation continues to develop.