By Atul Bhatia, CFA
- Without legislation to raise the nation’s borrowing limit, the U.S. will likely be forced into a debt default, conceivably as early as next month.
- The politics and negotiations of raising the debt ceiling are complicated, and we walk through a few scenarios and their possible market implications.
- While we do not see the U.S. defaulting this year, we think the political and economic backdrop to this negotiation is one of the most challenging we’ve seen, and we question how many more cycles can pass before the U.S. is forced to use legal loopholes to pay its debts.
In prior commentary, we held out a slender hope for a possible de-escalation in debt ceiling negotiations that would allow the U.S. to sidestep default concerns and a bruising political process. Not surprisingly, that hope is fading with hardening and contradictory stances from House Speaker Kevin McCarthy and President Joe Biden.
Adding to the tension is updated tax receipts data. The mid-April cash haul from personal income tax payments was lower than expected, and the Treasury Department now estimates that the U.S. will default in early June, weeks before corporate quarterly tax payments are due. Following the update, President Biden invited Congressional Republican leaders to the White House to discuss the situation, but as yet there has been no Republican response. We believe a permanent solution by June 1 is very unlikely, but we would not be surprised if the parties were able to reach a stopgap measure that lasted until mid-June. The influx of corporate tax cash would likely push back the deadline to raise the ceiling, frequently referred to as the X-day, until late July and allow a more realistic timeline for a final deal.
Markets have begun to be impacted by the lack of progress. The cost to insure against a near-term U.S. default has spiked, with investors now paying a 1.77 percent premium for 1-year credit default swap protection. The previous record – which was less than half of current levels – was set during the 2011 debt ceiling negotiations.
We still see no realistic possibility 2023 will be the year the U.S. defaults on its obligations, but we cannot rule out a damaging process with negative implications for short-term and long-term economic growth. Below, we lay out some of the scenarios we’re considering and the key indicators we are looking at as the debt ceiling discussion heats up in Washington and on Wall Street.
What comes next?
We group the likely outcomes based on when the ceiling is raised relative to the X-date. The closer we get to default, the worse the outcome, we believe, from the perspective of market and economic performance over the next 12 months. We appreciate the risks of the U.S.’s fiscal trajectory and believe budgetary changes need to occur, but we think adding a new layer of default risk only adds to the fiscal challenge.
Narrow path to early raise
The best outcomes would involve an early debt ceiling raise or suspension, potentially coupled with a fiscal adjustment or the establishment of a bipartisan commission on bringing tax receipts and spending levels closer together. Any raise that takes place more than two weeks before the estimated drop-dead date should be considered a good outcome, in our view. We think this outcome is still possible, but unlikely and becoming more difficult as the political parties ramp up rhetoric.
The catalyst for an early raise would be House Republicans prioritising likely future national electoral success. There are multiple signs the economy is weakening, and a relatively clean debt ceiling raise would limit the likely blame attached to Republicans for any recession. If the ceiling raise is contentious, there is a possibility voters will blame economic problems on legislative intransigence.
Arguing against this outcome is the House Republican caucus, which elected McCarthy on the condition that he use the debt ceiling fight to secure their budget priorities. Even if the clean raise would play well with swing voters at the national level, it would likely be viewed negatively by a meaningful percentage of Republican primary voters. Any House supporters of a clean raise would likely face significant primary challenges.
Even if there are sufficient votes in the House for a debt ceiling bill that would pass the Senate, it’s unclear if a floor vote could be held. It’s unlikely, in our view, that any House Speaker proposing an early vote could keep the role long enough to move legislation forward, and the procedures to force a vote without the Speaker’s approval are likely too slow-moving to be practical.
We would expect a meaningful, but likely short-lived, positive market response if the ceiling were raised in a relatively non-contentious manner.
Base case is bad, but could be worse
Bad outcomes are the base case. For us, this is any debt ceiling raise that takes place within the two weeks of the drop-dead date, although we imagine the actual raise will occur within days, and potentially hours, of the cutoff. We view this as a repeat of the 2011 debt ceiling raise, with last-minute brinkmanship, hasty budget changes, and no fundamental improvement to the U.S. fiscal or political situation. In short, business as usual.
There are a few variants to this scenario. One would be the House voting down a bill that is presented as the “last chance” to pass the ceiling. If this occurs, we anticipate a repeat of the first TARP (Troubled Asset Recovery Program) vote during the Global Financial Crisis, where Congress initially rejected the bill, the market sold off meaningfully, and then Congress hastily passed the program.
There are also potential procedural hurdles getting debt-ceiling legislation to a vote. Under the current House rules, any member can bring a priority motion to remove the Speaker. This would require the House to suspend other business – such as a debt-ceiling bill – and vote on whether to keep the Speaker in his position. With the Republicans enjoying a relatively small majority in the House, even a handful of holdouts from the majority party could lead to an empty Speaker’s chair. This would effectively paralyze the House, in our view, keeping it from considering any legislation, including debt ceiling raises.
We believe there would be sufficient bipartisan support to seat a Speaker long enough to pass the debt ceiling bill, although a last-minute objection would increase the likelihood of a short delay in payments that could constitute a so-called “technical default.” Like the failed vote, we see procedural uncertainties likely sparking large, but short-lived, market selloffs.
More generally, we see a last-minute ceiling raise as likely to cause higher volatility and a potentially large drawdown in risk assets. Such a reaction may, in fact, be necessary to provide political cover to Congress to raise the ceiling. We anticipate a relatively fast recovery, but we are not convinced markets will return to the pre-drawdown level.
Longer term, we see a contentious process as a negative for economic growth. One reason is simple math: budget contractions would lower the fiscal impulse, or the government’s contribution to GDP. Even though savings would likely prove ephemeral, the impact on 2024 growth could be meaningful. Another driver would be higher borrowing costs for the government and private investors, as default concerns push Treasury yields higher than they otherwise would be. The risk of higher borrowing costs would be heightened, in our view, if the U.S. sovereign credit rating were cut below AAA, the highest category. One agency already took away AAA status from the U.S. after the 2011 debt ceiling fight and a similar move by another agency could lead to forced selling by some investors. Finally, we also see a risk that the House will decide to elect a new Speaker, a process that will likely prove difficult to resolve and could lead to an extended period of legislative inactivity.
As mentioned, we do not think the U.S. will default this year. We believe a realistic worst-case scenario for this summer would be if the U.S. is forced to use a non-legislative action to avoid default.
One such manoeuvre would be minting a trillion-dollar coin – a solution based on collectible coin legislation that just happens to contain broad language authorising the Treasury Secretary to mint any denomination platinum coin, which could theoretically be used to fund the government.
Another (slightly less peculiar) method would be to exchange existing Treasury bonds for ultra-high coupon bonds. The debt ceiling is calculated on the face value of debt, so it would be possible to reduce the counted debt by reclassifying some principal repayment as interest. There have also been proposals to ignore the debt ceiling, relying on the public debt clause in the 14th Amendment to the U.S. Constitution as justification.
These are all, obviously, no way to run a railroad, and we think the use of any of these vehicles would likely cause a meaningful repricing in risk assets, driven by loss of investor confidence and the implications of additional political dysfunction.
We do not see this as a likely outcome, but we do not think it is impossible. One way would be if the House finds itself without a Speaker. Another would be if there is a political calculation that the best achievable electoral outcome for the House majority would be the Biden administration taking unilateral actions to end-run the debt ceiling.
Not now doesn’t mean never
Even though we do not see the first U.S. default occurring this year, we acknowledge that on the current trajectory we are likely only a few negotiation cycles away from the U.S. being forced to rely on legal loopholes or commemorative coins to maintain performance on its debt. We appreciate the view that U.S. fiscal policy is unsustainable, but we believe that it is contrary to the national interest to create uncertainty around the country’s willingness to repay its obligations.
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