The risk of recent interest rate hikes by the Federal Reserve seems to be twofold: the direct impact of a possible debt ceiling breach on the funds and the larger shockwaves that would send through the financial markets.

Unlike money market deposit accounts, money market funds invest in short-term, low-risk debts, such as Treasury bills. This approach makes them a suitable choice for short-term investment goals. Due to their close alignment with the fed funds rate, which is currently sitting at a target range of 5%-5.25%, the leading money market funds are now yielding close to or above 5%.

Money Market Mutual Funds

Money market mutual funds are a popular financial vehicle, acting as an intermediary for investors looking to secure their funds in a lower-risk, short-term setting. Such funds are an appealing alternative to conventional savings accounts or bank deposits, particularly in a scenario where the Federal Reserve has initiated a series of interest rate hikes.

Their investment philosophy typically revolves around short-term debt, such as Treasury bills, which are generally perceived as secure. Because the returns or yields of these funds closely trail the Fed funds rate, any changes by the Federal Reserve can significantly influence the attractiveness of the American funds money market.

However, the current political climate and escalating tensions regarding the U.S. debt ceiling are casting a shadow over these funds. The fear of a possible default by the U.S. government on its debt obligations due to a debt ceiling breach is creating a ripple of anxiety among investors. The situation is exacerbated by the fact that a significant portion of the funds' portfolios is invested in Treasury bills, which would directly be affected by any potential default.

The Recent Shift

On May 9, money market fund assets saw a record surge to $5.685 trillion, driven partly by the inflows from the collapse of Silicon Valley Bank and Signature Bank in March.

A recent banking crisis has led to a massive shift of deposits from banks to market funds, lured by their higher interest rates. Over the past year, bank deposits reduced by almost $1 trillion, while the AUM of the American money market funds swelled by $700B. This trend isn't new; since the beginning of 2020, AUM has spiked by $1.7 trillion, reaching 5.7 trillion Dollars. However, the ongoing stalemate over the national debt had also jeopardized over the year this status of the so-called "X-date" - the date when the Department of Treasury exhausts all possible consequences to bypass a breach of the debt ceiling of $31.4 trillion.

The Funds of the money market are exposed to disturbances in the Treasury market, as they hold substantial amounts of bills. It was no coincidence the government money market funds, which have an AUM of $4.4T, evenly split, merged portfolios equally between Treasury bills as well as providing to the Fed through the facility of the Overnight Repo Reverse.

The X-Date

Uncertainty is escalating as the X-date slowly ascends and goes. Premium Insurance investors pay against default for protection, known as Credit Default Swap (CDS) spreads, have soared to a record of over 160 basis points. As a result, investors are shying away from the maturation of the T-bills immediately after X-date, forcing their yields up. For instance, one-month yields, T-bills started ripening on June 6 and spiked to 5.7%, which according to the calculation, is 240 bases higher than 14 days prior. Such sudden and drastic yield increases depress the price agenda of income tools like T-bills, resulting in mark-to-market mislay at the funds of the money market.

If the ceiling of debt isn't awakened and acknowledged at the right hour to prevent the US credit rating will be brought down to The RD (Restricted Default), impacted Treasury securities will bear the D rating up till the time the default is notified. Even if the government prioritizes debt servicing over other obligations—a politically contentious decision—, it won't align with an AAA surplus rating. S&P, a major agency, has already brought down the US back in the year 2011.

Potential Mark-to-market Losses

The potential mark-to-market losses and credit grades down of the Treasury securities, Initially primary assets held by money market funds, could cause anxiety among clients, triggering some to transfer their money brought about elsewhere. This outflow further destabilized the already turned critical element financial markets, struggling with the crisis of banking at a regional level, the interest rates, and credit so high. Consequently, the present debt impasse might have a more significant impact than in the last few in 2011 and counting 2013 as well.

In response to this uncertainty, money market funds could lend an advance to Fed through the facility of REPO reverse. However, this action would drain more liquidity from the system of finances, amplifying the usual upshots of the (QT) Quantitative Lightening that the Fed implemented back in June 2022 to reduce the holding of the securities of the government by $95B per month.

The political battles surrounding the debt nationally are raising the likelihood of a severe recession, coming at an unfavorable time. The recurrent mini crises caused by the disputes debt ceiling are eroding the reliability, anticipation, predictability, and trustworthiness of the United States government.