The debate around the US debt ceiling is back again. While our base case is that Congress eventually will increase the debt ceiling, as it has in every past episode, we expect that process to be unusually messy this year. And the risk of an “accidental” default is higher than ever.
Earlier this week, Treasury Secretary Janet Yellen announced that the US Treasury had hit the debt ceiling and would be forced to rely on extraordinary measures to meet its obligations until Congress passes legislation to increase it. While these measures are deemed “extraordinary,” the debt debate happens so often that it has started to feel ordinary. Even if Congress eventually does increase the ceiling, we expect the debate to rattle financial markets over the summer as the game of chicken plays out and the risk of an unintended default grows.
What’s the Debt Ceiling?
As a refresher, the debt ceiling is a statutory rule that requires Congress to authorize the Treasury to borrow money. The debt limit itself has nothing to do with government spending plans, which are passed during the budgetary process. The fiscal 2023 budget was actually passed late last year. In essence, the debt ceiling is simply a vote to authorize the government to spend what it’s already committed to spending.
The ceiling was bumped up three times under the previous presidential administration without incident, but with Democrats controlling the White House and split control of the legislative branch, the ceiling becomes leverage for Congress to try to extract spending cuts from the administration if they don’t happen during the budgetary process.
Why Would an Impasse Be Disruptive?
The role of US government debt in the financial system is unique. Treasury securities are generally viewed as “risk-free,” meaning they’re used in ways that go beyond mere investments. Treasuries are used as hedges against investments perceived to be riskier. They’re also used as collateral in short-term trades that allow banks to fund themselves and maintain liquidity. Insurance companies, sovereigns, and other large borrowers hold massive amounts of Treasuries as reserves.
If Treasuries cease to be risk-free, it could upend parts of the financial system in unpredictable ways. This unpredictability is the foremost risk—the truth is, nobody really knows what a US sovereign default, even for a short period of time, would look like. It is an unprecedented event for which investors have no real hedge.
Of course, this isn’t the first time the debt ceiling has been a concern. The most obvious parallel to the current situation was the 2011 episode, in which Congress and the Administration dragged out negotiations until very near the last minute, resulting in a downgrade to the US sovereign credit rating.
Hard to Project the “Drop-Dead” Date
It’s impossible to predict the “drop-dead” date—the moment when the government’s spending ability will be exhausted—too far ahead of time. The exact timing will depend on government revenue flows in the coming months. We estimate that the extraordinary measures will last into the third quarter and that Congress won’t get serious about addressing the issue until then, as has been the case in the past. Markets seem to agree with that timetable—there are currently no disruptions priced into funding markets through the summer.
Negotiations Will Be Very Messy
What will negotiations look like as the end of the road approaches? We think they’ll be even messier than in 2011. Some Republicans seem willing to risk default in order to extract spending cuts. We think that’s a minority view, but the slim Republican majority in the House of Representatives suggests that a small group opposed to compromise holds outsized power, as negotiations around the speaker’s position revealed.
This situation makes it more likely that a bipartisan coalition will be needed to approve the debt ceiling increase, which is in short supply these days, particularly on issues related to government funding. So, while we expect that, in the end, the prospect of a government default will prove too frightening for Congress to ignore, the risk that political considerations lead to an “accidental default” in which a compromise can’t be reached in time is uncomfortably high.
Unpredictability Is the Name of the Game
In 2011, financial markets suffered as the debate extended into the summer. Equity markets fell more than 15% as the deadline approached and investors became more alarmed. Paradoxically, Treasury yields fell—investors bought Treasuries even as they became more concerned about default and even as the risk of a sovereign downgrade rose. At the time, the combination of falling stocks and the belief that any default would be very short-term and much more likely to impact Treasury bills than longer-term bonds were enough to convince investors to buy Treasuries.
Will that happen again? It’s hard to say, and that unpredictability is what investors must keep in mind. Yes—it’s most likely that Congress will eventually find a way to get the job done. But that path is going to be rocky, and the risk that the dance with the debt ceiling will be different this time seems greater now than it ever has before.
- Eric Winograd
- Senior Economist—Fixed Income