You Really Don’t Want to Hit the Debt Ceiling
What happened last week?
When the US Congress created the “debt ceiling” during World War I, its intent was to speed along government spending while maintaining a way to ensure responsible borrowing. The US debt ceiling has been raised or suspended nearly annually since 1917.
A century later, the unintended consequences of having to pass legislation to borrow — separately from passing legislation to spend — were unimaginable.
The debt ceiling is unique to the United States. Congress passes a budget, the government spends the money and, when there is insufficient revenue, the Treasury borrows money to fully fund the expenditures.
After the money is being spent — and just as the government’s borrowing is about to hit the previously approved ceiling — new debt ceiling legislation is required. This process is wholly unnecessary and allows partisans to interfere with earlier spending decisions under the threat of catastrophic default.
- The S&P 500 shed -0.30%
- The Dow Jones sank -1.03%
- The Nasdaq composite ticked up 0.40%
3 Things to Know
Debt ceiling brinksmanship on repeat
The US Treasury is the world’s largest sovereign borrower in its own currency. US government bonds serve as the most widely used form of collateral in global banking and comprise the slight majority of the foreign reserves of the world’s central banks.
Failure to service and redeem US Treasury debt on time would indeed generate an unnecessary shock of severe and unpredictable size. The credibility of US government support for the banking system would be undermined.
Numerous US spending commitments, including national defense spending, would be “unfunded.” Delayed payments would almost certainly trigger defaults from others dependent on Treasury interest payments and redemptions.
The repeated rounds of political theater over the debt ceiling have left markets numb to the nearly annual event.
After a “close to the brink” set of compromises in 2011, several ratings agencies downgraded US Treasury debt and US equity markets fell more than 15%. Yet there were no lasting consequences for US borrowing costs and the stock market recovered in full.
Despite this, in the current market context, we believe a repeat of the brinksmanship could add to the perceived riskiness of investing in US dollar assets.
Last-minute compromise is likely
As of May 10, the US Treasury had $155 billion in cash in hand, having taken “extraordinary measures” to reduce borrowing to remain under the $31.4 trillion statutory debt limit since the start of 2023.
Operating cash is below two weeks of expenditures. In fact, Treasury Secretary Janet Yellen said the US may have no ability to pay all its obligations in full as of June 1.
Interestingly, the fear over late redemption of Treasury bills has caused a large distortion at the front end of the US Treasury market. Bills that mature just before June 1 yield roughly 125 basis points less than those maturing after. A last-minute compromise between the administration and Congress over the debt ceiling is quite likely.
The political motivation to reach a compromise would skyrocket if payments were delayed to the many millions of Social Security recipients, doctors, federal employees, and private contractors who do business with the US government.
Such a calamity would result in a surge in private defaults unless the situation was quickly remedied.
Markets are distorted by the debt ceiling impasse. The probability of a late July rate cut by the Fed has reached 38%. The chance of a move by September has reached 63%. However, we believe these Fed easing expectations will diminish if a deal is reached.
Without a debt ceiling crisis, the Fed is more likely to maintain higher rates for longer until real unemployment rates rise. So far, equities and credit markets have been little impacted by the fiscal drama.
However, investors in US equities must keep in mind that any fiscal compromise that reduced spending will likely come at the expense of medium-term US growth. It may affect the profits of some firms that have benefited directly or indirectly from deficit spending.
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