By Richard Leong
NEW YORK (Reuters) - The fight over raising the U.S. debt ceiling is starting to rattle the money markets and could eventually disrupt the flow of cash needed for banks to lend and companies to invest.
As an impasse over the federal budget lengthens the first partial government shutdown in 17 years, there are increasing fears among investors that the White House and Congress won't reach an agreement to raise the $16.7 trillion (10.42 trillion pounds) debt limit by an October 17 deadline. That raises the risk of a first outright default in U.S. history.
Most analysts believe an outright default, in which the U.S. Treasury Department has no intention to fully pay back its debt obligations, is a remote possibility since it would wreak havoc on global financial markets and damage the long-term safe-haven status of U.S. debt and currency.
Even so, markets are starting to reflect the view that a short-term delay in payments is possible.
"The market is incorporating chances of a delay in payments," said Dave Sylvester, head of money markets at Minneapolis-based Wells Capital Management, which manages $131 billion in money market assets.
Traders are demanding higher interest rates against the chance that the Treasury could delay coupon and principal payments on specific securities.
Other money markets are showing no signs of panic. The overnight borrowing costs in the repurchasing market, which banks use to fund their operations, crept up this week but they were running below T-bill rates.
In the interbank lending market, the three-month London interbank offered rate - which is used to setting the interest rates on some $350 trillion of financial products - fell to a record low this week.
The U.S. government technically defaulted in 1979, but the incident was brushed off as a short-term event that stemmed from a paper logjam at the Treasury and affected only a few minor securities.
This time, the threat has galvanized investors, leading them to lighten up on Treasury bills that mature in the second half of October. That sent interest rates on Thursday to their highest in nearly a year. During the last showdown in Washington over the debt ceiling in 2011, short-term bill rates also spiked.
The interest rate on a Treasury bill issue due on October 31 traded as high as 0.19 percent on Friday, the highest among all T-bills on the open market. It last traded at 0.13 percent.
The rate on this T-bill issue, which has $89 billion outstanding, according to Reuters data, was as much as five times the rates on T-bills maturing late November.
Wells Capital's Sylvester and other analysts said that while T-bill rates have risen in recent days, the overnight costs in the repo and federal funds markets have stayed in the single digits, signalling some confidence of a debt ceiling deal before the deadline in less than two weeks. The repo action suggests investors are willing to lend their cash rather than deposit it with banks.
"We are still quite sure we'll see a rise in the debt ceiling in the next week or so," said Perry Piazza, director of investment strategies at Contango Capital Advisors in San Francisco.
Still, agreement in Washington remains elusive, with the partial government shutdown that began on Tuesday appearing likely to drag on for another week or possibly longer, with the next crisis in sight on October 17.
President Barack Obama has urged Congress to pass a spending bill, while many Republicans refuse unless Democrats yield to their demand to change Obama's healthcare reform law.
RISK CONTAINED FOR NOW
Specifically for money markets, where companies and governments raise short-term cash to fund inventories and paychecks, a failure to raise the debt limit would mean investors will not get back their money on time. This could cause money funds to liquidate other assets if they need to raise cash because shareholders are seeking to exit en masse.
"That's an incredible threat," said Lance Pan, director of investment research and strategy with Capital Advisors Group in Newton, Massachusetts.
Such a move could pressure repo and other short-term interest rates higher, although money market mutual funds have so far clung to their holdings of repos and T-bills. JPMorgan analysts said in a research report published late Wednesday that some dislocations in the repo markets are likely.
The $2.7 trillion money fund industry owned about $477 billion in short-term Treasury securities at the end of August. Of this amount, it held almost $100 billion in debt that matures between mid-October and mid-November, the JPMorgan report said.
FED AS UNINTENDED BACKSTOP
If the White House and Congress cannot reach a deal on the debt limit, the impasse would stop the government from issuing Treasury bills, forcing money market mutual funds and other cash managers to scramble for alternatives to park their money.
In a convenient coincidence, the Federal Reserve could end up being a backstop in case the Treasury cannot sell more debt, analysts said.
Last week, the central bank started testing a program on reverse repurchase agreements in which it sells its Treasuries to banks, money funds and mortgage agencies. The Fed buys back the bonds and pays interest on the reverse repos the next day.
This program is intended to help the Fed achieve its interest rate target when it decides to end its near-zero interest rate policy.
It could take on additional significance because dealers need Treasury securities on a daily basis as collateral in transactions with other investment firms. If the supply of Treasuries is constrained by the government's inability to sell debt, even temporarily, the Fed's existing stockpile of bonds would come in handy.
"They might actually alleviate a squeeze in the supply situation if it were to happen," Pan of Capital Advisors said.
The daily amounts involved in the Fed's reverse repo test have been generally modest. On Thursday, it was only $2.3 billion, after it totalled $58.2 billion on Monday, which analysts attributed to short-term funding needs at quarter-end.
The Fed, which has set the reverse repo test rate at 0.01 percent, said the tests could keep going through into late January.
The extended run may prove beneficial, with the timing of a debt deal still unknown and money markets approaching uncharted waters if the U.S. defaults.
"We have never gone through this. We just don't know," Pan said.
(Reporting by Richard Leong; Editing by Grant McCool)