Why Investors Clinging to Cash Could Lose Money in the U.S. Debt-Ceiling Fight

As the U.S. approaches a potential crisis in the debt-ceiling negotiations, investors who are holding onto cash may soon find themselves on the losing end of the financial equation. With indications that the Treasury will soon have to implement “extraordinary measures” to manage its obligations, the supply of Treasury bills—a cornerstone of short-term government debt—could decline significantly in the coming weeks.

The Background of the Debt Ceiling

The current debt ceiling situation was reset when Congress suspended it through January 2025, capping the limit at $36.1 trillion. Despite a last-minute agreement in December to prevent a government shutdown, the underlying issue of the debt ceiling persists, leaving investors in a precarious position.

In a letter written at the end of December, Treasury Secretary Janet Yellen cautioned that the U.S. could hit its debt limit between January 14 and 23. This scenario would force the Treasury to initiate extraordinary measures to continue meeting its financial obligations. Deborah Cunningham, the Chief Investment Officer for global liquidity markets at Federated Hermes, indicates that the market is bracing for these measures to take effect within the last two weeks of January. “It’s going to be impactful,” she said.

The Risk to Treasury Bills

The implications of the ongoing debt-ceiling disagreement are most pronounced in the massive $7 trillion Treasury bill market. T-bills, which are short-term government securities with maturities of one year or less, face a substantial risk if issuance drops due to prolonged negotiations around the debt ceiling.

The previous two debt-ceiling crises led to negative bill supply, and the same result is possible if the current deadlock continues. The declining supply of T-bills is particularly concerning for the money-market fund industry, which has expanded from $4 trillion in 2020 to approximately $7 trillion. This growth is attributed to investors looking for safer investments after several regional banks collapsed in 2023, and to the appeal of higher yields of 4% to 5% offered by money-market funds, which primarily invest in T-bills.

Portfolio Implications

According to Cunningham, if the debt ceiling is not resolved, the available T-bill market, currently at $10 trillion, could shrink by as much as 30% to approximately $7 trillion. This reduction poses a significant challenge, as it will likely lead to lower yields across investment portfolios. “But ultimately, the impact of all portfolios is going to be marginally lower yields,” Cunningham added.

Market Reactions and Future Expectations

The financial markets experienced a strong upswing following the election, often termed the “red sweep” by Republicans, which had initially alleviated some concerns. However, bond yields, which move inversely to prices, have increased as worries arise about potential economic policies during a second Trump administration. Such policies may include more tax cuts and tariffs, potentially exacerbating inflation and increasing the national debt.

Despite the existing tensions, some analysts, like Amar Reganti—a fixed-income strategist at Hartford Funds—assert that financial markets currently show no alarming signs of liquidity stress. This relative calm is partly due to expectations that the Treasury could manage operations under extraordinary measures until the summer, when the stakes of a default could escalate.

Cash Reserves and Further Risks

User cash reserves at the Treasury General Account at the Federal Reserve currently stand around $677 billion. This amount has been drawn down during previous debt ceiling crisis periods. However, as analysts like John Velis of Bank of New York Mellon point out, once an agreement is reached, there may be a quick drainage of these reserves as the Treasury works to replenish its cash balance. This situation could further induce volatility in funding markets and complicate the Federal Reserve’s balance sheet reduction strategy.

The Bigger Picture

Despite the anxiety surrounding the debt ceiling and its potential to cause disarray, historical patterns suggest that the U.S. Congress often resorts to raising the borrowing limit, usually at the very last moment, to avert disaster. Nevertheless, the investors who prefer to remain conservative and cash-rich are positioned to feel the most significant impact from this ongoing battle.

As the situation unfolds, it becomes paramount for cash-holding investors to keep a close eye on developments in the debt ceiling negotiations. With the potential for diminished Treasury bill supply and subsequent lower yields impacting their portfolios, the pressing question remains: how prepared are these investors for the expected turbulence ahead?