Default anxiety ripples across U.S. short-term rates market

NEW YORK Fri Oct 11, 2013 3:39pm EDT

NEW YORK (Reuters) - Fading hopes the United States will raise the debt ceiling in time to avert a default have rattled funding markets, as traders now expect Washington might not reach a deal until the end of the year.

Banks and money market funds have shed U.S. Treasury bills that mature through the end of the year, briefly sending their interest rates to the highest since the 2008 global financial crisis.

The latest showdown between the President and the Republicans over the budget has undermined investors' confidence in Treasury bills, which had been seen almost as good as cash due to the short maturity backed by the full faith and credit of the U.S. government.

The fear is that the United States might delay payments on its debt, as President Barack Obama and Republican lawmakers have made little progress toward raising the $16.7 trillion debt limit, which would be exhausted on October 17.

"As the week progressed, you have seen an increase in volatility," said Jill King, partner and senior portfolio manager at Horizon Cash Management LLC in Chicago.

Interest rates on the T-bill issue due that day, what traders dubbed the "drop dead date," traded above 0.50 percent on Thursday, or about 15 basis points above the yield on a two-year Treasury note. The October 17 T-bill rate retreated to 0.26 percent on Friday, which was still double the level a week ago.

Friday's decline was in response to talk the debt ceiling could be raised through late November - which in turn inspired selling in issues maturing in December, as those are now seen as riskier.

Interest rates on T-bills that mature from Oct 24 through the end of the year ranged from 0.18 percent to 0.32 percent.

"All the bills that would be at risk will probably continue to reflect nervousness until we do get the longer term increase in the debt ceiling," said Ira Jersey, interest rate strategist at Credit Suisse in New York.

Major money market mutual funds, including Fidelity, J.P. Morgan and Pimco have shunned T-bills most vulnerable to the government missing its October 17 debt ceiling deadline.

BlackRock said its money funds have no holdings in T-bills due in late October through early November.

"We continue to take prudent actions in preparation for all potential outcomes, despite our belief that Congress and the President will likely act to prevent a U.S. default," the world's largest asset manager said in a statement to Reuters.

As the government's short-term borrowing costs have jumped, borrowing costs for companies, banks and Wall Street have climbed in the past 72 hours, signaling traders' worries the Washington impasse over the debt ceiling might drag on much longer than they had expected just a week ago.

On Wall Street, U.S. stocks rallied sharply on Thursday and extended gains on Friday on faint signs of progress for a deal. However, an actual agreement has not yet come to pass, with negotiations expected to continue through the weekend.

The fight has also resulted in the first government shutdown in 17 years, which led to the furlough of at least half a million federal workers and contractors. This development also knocked U.S. consumer sentiment to a nine-month low, just weeks before the start of the year-end holiday shopping season.

Concerns over delayed interest and principal payments on Uncle Sam's debt have spilled over to the $5 trillion repurchase agreement market where banks and Wall Street firms pledge their T-bills as collateral to raise cash to fund their daily operations.

"In the repo market there are a lot of people that said they would like to replace whatever at-risk collateral they can for other collateral," Credit Suisse's Jersey said.

The overnight interest rates on repos backed by Treasuries traded to a four-month high near 0.25 percent on Thursday before easing to 0.19 percent on Friday. A week ago, they were at 0.09 percent. Some of the move on Friday was in anticipation of the long weekend, as U.S. bond markets are closed on Monday for the U.S. Columbus Day holiday.

Still, while short-term rates have jumped, they remain very close to zero and would fall quickly when Washington reaches a debt deal.

On the other hand, short-term rates might resume their rise if the President and Republicans remain far apart in raising the debt ceiling, or produce a very short-term solution that will result in another fiscal showdown before year-end.

"If this carries into next week and we don't see a longer-term settlement in raising the debt ceiling, you will see a lot more volatility," Horizon's King said.

(Additional reporting by Karen Brettell and Ashley Lau; Editing by Chris Reese)

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