In recent weeks, public discourse here inside the Beltway (and on Wall Street, and within various other corridors of power near and far) has focused on the need for Congress and President Obama to reach agreement on raising the federal debt ceiling by Oct. 17, lest they risk enormous consequences to the markets and the economy as a whole.

Strictly speaking, that is not true. Not because there aren’t actions the administration could take to avoid defaulting on the public debt even if no deal is reached (there almost certainly are) and not because the consequences of pushing beyond the Oct. 17 deadline wouldn’t be unfathomably risky (I’ll get to that in a bit.)

No, the bit that is irrefutably untrue regards the debt ceiling itself: we actually reached the statutory debt ceiling last New Year’s Eve.

Let’s first offer a brief recap of how we got here, and then a bit on where we might be going:

To sum up – the federal government reached its $16.4 trillion debt limit last New Year’s Eve. It then chose to ignore the debt ceiling for a few months. It reinstated it at the new level of $16.7 trillion in May, and the various patchwork budgetary games Treasury has been playing to avoid breaching even that level have now largely run their course.

That doesn’t mean the government is completely out of money. In addition to the $30 billion on hand, tax revenues do continue to flow in. To avoid a true “default,” Treasury would need pay lump sum interest payments of $5.9 billion on Oct. 31 and then a larger $30.9 billion on Nov. 15, and there appears little actual risk that it wouldn’t be able to do that.

However, as we move in the direction of default, there are any number of problems that begin to gum up the works in financial markets. Ironically, the one most commonly cited – that Treasury yields will begin to spike as investors demand a risk premium on government debt – doesn’t appear very high on that list. Just as they did following the August 2011 downgrade of U.S. government debt by rating agency Standard & Poor’s, Treasuries have been rallying of late. Yesterday, the benchmark ten-year note closed with a yield of 2.62 percent, down from 2.65 on Friday and way down from the 3.00 percent they were yielding just a month ago.

The market reaction, while counter-intuitive, does contain a certain perverse logic. In any period of uncertainty, investors gravitate toward the safest asset. Any risk that the United States – the largest issuer of bonds in the world, as well as the minter of the world’s reserve currency – would be delinquent in paying its obligations is going to be a huge source of uncertainty, leading investors to shed all sorts of asset classes. But since many are constrained to holding dollar-denominated assets, the net inflows of money out of equities and into Treasuries could (and by all lights, likely will) exceed the outflows of money from Treasuries into….

…well, that answers the question right there. Into what? It’s awfully hard to stuff $16 trillion into a mattress.

Rather, the area where breaching the debt ceiling could have the most devastating impact is in the $4 trillion “repo” market. Repo agreements allow banks, hedge funds and other short-horizon investors to borrow large sums in the overnight market from longer-term players like pension funds, life insurers and money-market funds, mostly by pledging the safest and most liquid asset around – U.S. Treasuries – as collateral. The market serves as the heart of the so-called “shadow” banking industries, and trillions of dollars of short-term commercial loans are tied to its effective functioning.

Unfortunately, the hard cap on new government borrowing threatens to greatly exacerbate a problem those markets have been dealing with all year: a notable shortage of Treasuries.

Part of this shortage is a direct result of the Federal Reserve’s quantitative easing program, in conjunction with lower levels of Treasury issuance overall. As reported last December by Bloomberg:

The government will reduce net sales by $250 billion from the $1.2 trillion of bills, notes and bonds issued in fiscal 2012 ended Sept. 30, a survey of 18 primary dealers found. At the same time, the Fed, in its efforts to boost growth, will add about $45 billion of Treasuries a month to the $40 billion in mortgage debt it’s purchasing, effectively absorbing about 90 percent of net new dollar-denominated fixed-income assets, according to JPMorgan Chase & Co.

By March, supply of 10-year Treasuries had fallen so much below prevailing demand that the repo rate on 10-year Treasuries actually fell into negative territory:

The Treasury Department asked today for information about positions in 2 percent notes maturing in February 2023, with a threshold of $2 billion as of the close of business on March 11. The on-the-run, or most actively traded 10-year note, came into short supply in the repurchase agreement market that investors pay interest on cash lent to borrow the debt, resulting in a negative repurchase agreement rate. The Treasury sold an additional $21 billion of the notes on March 13.

The repurchase agreement, or repo, rate on the benchmark 10-year note closed with the lowest repo rate for all specific securities, at negative 2.95 percent on March 13, according to data from ICAP Plc, the world’s largest inter-dealer broker. The repo rate for the note opened yesterday at negative 2.8 percent and closed today at 0.02 percent. The overnight general collateral Treasury repurchase rate opened today at 0.25 percent.

The Fed’s announcement in June that it would begin tapering its QE program this fall was expected to take a hit on bond prices generally, and they did fall 17 percent from May through early August. But Treasuries remained oversold, even before the Fed reversed course on its tapering plans.

Which brings us to where we are today. To the extent the paucity of Treasuries was already causing problems in the short-term lending markets, the debt ceiling is set to make those problems significantly worse. Treasury would still continue to issue notes and bonds, but only to roll over older issues that mature.

If there’s any rise in borrowing costs (something that is not altogether unlikely for shorter-term T-bills) the additional interest would count as expenditure, crowding out principle and further reducing the amount of debt that could be issued.

The generally chaotic economic environment that would be expected to accompany any real threat of default also would all but assure that the Fed will continue full speed ahead on its QE program, reducing the volume of government securities available to private investors even further.

Perhaps the impact of all of these developments wouldn’t be catastrophic. Perhaps the repo markets would find other ways to collateralize their trades. Perhaps other sources of short-term liquidity would emerge.

And then again, perhaps not.

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