3 Things to Know
Brinksmanship on Repeat
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.
Last-minute Compromise Likely
A last-minute compromise between the US administration and Congress over the debt ceiling is likely, in CIO’s view. House Republicans demonstrated that they could raise the debt ceiling unilaterally in a vote taken on April 26. It slashes US spending by about 1.5 percentage points of GDP annually over the coming decade. However, it makes many cuts in areas prioritized by Biden and the Democrats that will make bipartisan agreement unlikely.
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.
US President Joe Biden has ruled out debt default. Republicans, who control Congress, have ruled out a US debt ceiling increase without spending cuts. Biden must break the impasse in order for debt ceiling to be raised. While a last-minute compromise is most likely, we believe the US administration is willing to prioritize US debt payments (likely invoking the 14th Amendment), to avoid major financial consequences from missing Treasury bill redemptions and coupon payments. The most significant question is how much fiscal adjustment will be needed to get through this period? If the US had to live under the existing debt ceiling without new net Treasury issuance, it would have to cut non-interest spending by at least US$150 billion immediately. If this was annualized, it would be a cut of nearly 7% of US GDP.
If a fiscal agreement comes before the debt ceiling is breached, the US bond market is likely to push out the possibility of rate cuts until late in 2023. Cyclical equities would likely rally, but interest-rate sensitive growth shares may fall.
Source: Haver Analytics as of May 11, 2023. Grey areas note recession. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Past performance is no guarantee of future results. Real results will vary.
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...globally. 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 Likely
As of May 10, the US Treasury had US$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. House Republicans demonstrated that they could raise the debt ceiling unilaterally in a vote taken on April 26. It slashes US spending by about 1.5 percentage points of GDP annually over the coming decade. However, it makes many cuts in areas prioritized by Biden and the Democrats that will make bipartisan agreement unlikely. It also includes areas where compromise is likely, such as unspent emergency Covid funding. CIO believes spending restraints similar to those reached after the rancorous 2011 debt ceiling battle are likely. With Biden negotiating for the Obama administration in 2011, the Budget Control Act of 2011 contributed to a small outright drop in federal spending in 2012-13.
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, CIO believes 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.
As we have seen dozens of times since WWII, when markets are confronted by potential shocks and they don’t occur, expectations swiftly adjust. Highly worrying threats of default in 2011 did not precede actual default. The market impact of the fear was therefore quite temporary. With this in mind, US officials should not (and the vast majority don’t) assume they can stretch their spending conflict beyond the brink without more serious economic consequences. CIO believes a compromise akin to the Budget Control Act of 2011 will be reached. But failing that, defaulting on non-interest obligations would still have severe economic consequences. Even if it lasts for a very short time, it may set a bad precedent and hurt consumer confidence. If a fiscal agreement comes before the debt ceiling is breached, the US bond market is likely to push out the possibility of rate cuts until late in 2023. Cyclical equities would likely rally, but interest-rate sensitive growth shares may fall. Yet beyond this immediate impact, the weakening in US bank lending will still be felt in time in the economy and cyclical industry shares. While the US economy has been somewhat more resilient than we expected in early 2023, more fiscal restraint is also likely to come in any budget agreement.