MONEY MARKETS-T-bills more volatile as debt ceiling deadline nears

NEW YORK Wed Jan 16, 2013 11:14am EST

NEW YORK Jan 16 (Reuters) - Some fixed income investors are getting nervous that the United States may have to delay debt payments due in February and March, as negotiations in Washington over how to cut spending and raise the debt ceiling again look likely to drag out until the last minute.

The U.S. Treasury said on Tuesday it was temporarily tapping the retirement funds of government workers to avoid hitting the $16.4 trillion debt ceiling. It has said it can only stave off default through such extraordinary measures until around mid-February to early March.

Market reaction to the risk of a U.S. default so far has been relatively muted, but some investors are starting to pull away from Treasuries that mature in that time frame.

"There's been a little bit of volatility in the bill market. People are already avoiding some of the bills that expire right around the end of February and in early March," said Mary Beth Fisher, head of interest rate strategy at Societe Generale in New York.

Yields on some one-year Treasuries notes that mature on March 7, for example, have jumped to 10 basis points, from 2 basis points at the beginning of the year.

The cost of insuring U.S. debt in the credit default swap markets has also increased.

CDS that would insure against a default for 6 months have jumped to 20 basis points, the highest level in six months, and up from 8 basis points at the beginning of the year, according to data from Markit.

"We're seeing not only price action but we're seeing flows that are consistent with a bit of a fear. We think the bigger risk is in the Feb 28 to March 28 zone," said Kenneth Silliman, head of short-term rates trading at TD Securities in New York.

The delay in raising the ceiling is the second time investors have faced the possibility of a U.S. debt default. A standoff over the issue in mid-2011 led to Standard & Poor's downgrading the U.S credit rating from the top AAA.

This time around, many investors may be more prepared and more averse, and some fear market reaction could be worse.

Money market funds, which are large lenders in repurchase agreements that are backed by Treasuries and other collateral, are not allowed to accept defaulted bonds to back loans.

They pulled back from loans in 2011 and most expect they will again if the negotiations drag out.

"This time, flight risk is even higher," said Michael Cloherty, head of interest rates strategy at RBC Capital Markets in New York.

Most money funds loans are made overnight, which leaves banks and other borrowers vulnerable to sudden pullbacks. The funds also have the option to terminate any loans with seven days' notice.

Borrowers in repo also have the option to offer Treasuries as an alternative to mortgage-backed securities and other bonds used to back loans, which may mean asset aversion could spread to other markets and mortgage rates also risk a spike.

"We expect term financing liquidity to become very poor, and think there is real risk in financing rates rising sharply," said Cloherty.

Some hope that lawmakers are more aware of the dangers of dragging out the debate as uncertainty threatens to harm economic growth. There are also some reports that Republicans may shift the fight from the debt ceiling to the so-called "continuing resolution."

The failure to pass this measure would shut down the government, but avoid a more calamitous debt default.

That said, there are also dangers of too much complacency on the issue, or putting too much faith in U.S. politicians.

"Markets are likely to ignore the debt ceiling till the last minute, or even later, and then react on panic if it gets breached," Steven Englander, head of global G10 currency strategy at Citigroup, wrote in a note on Wednesday.