Over the weekend, U.S. President Joe Biden and U.S. House of Representatives leader Kevin McCarthy agreed to a deal to potentially resolve the U.S. government’s debt ceiling crisis that threatened a first-ever U.S. government default. Biden and McCarthy prioritized negotiations as Treasury Secretary Janet Yellen said the government could run out of money as early as June 5, the so-called X-date. While we see a number of potential complications as the deal goes through Congress, we think Congress will approve it.

What It Is

Biden, a Democrat, and McCarthy, a Republican, are counting on the deal to garner sufficient support in the House and Senate so that in can be enacted into law by the end of this week. Key components of the deal include:

• A debt ceiling extension through January 1, 2025, which is notable because it pushes the next debt limit debate past the 2024 presidential elections. It assigns a date but not a dollar amount to the debt ceiling, making it effectively a debt ceiling extension or suspension as opposed to a bill to lift the debt ceiling to a specific dollar amount.
• Six years’ worth of spending caps through 2029, but only two of which are enforceable in fiscal years 2024 and 2025. Our initial read suggests flat-to-slightly negative non-defense spending growth over the next two years. The estimate is complicated by the inclusion of several budgetary adjustments, off-paper agreements and other items allowing both parties to potentially claim victory. Republicans can claim cuts around 7% while Democrats can argue funding levels will be basically flat. Defense spending would rise modestly in fiscal year 2024 (3.3%) and 1% thereafter. Overall spending caps would rise 1% each year in the next six years through 2029. However, since caps are only enforceable in the first two years it is likely years three through six will be revisited down the road. As to the impact of less government spending, most early analyses of the deal project a small headwind to U.S. economic growth, in the range of a 0.1% to 0.4% reduction.
• A $2 trillion reduction, based on early estimates, in the budget deficit if Congress adheres to all six years of the caps. However, as mentioned above, only the first two years are enforceable and the details of the actual topline numbers aren’t clear. The Congressional Budget Office may release its evaluation this week.
• Some limited reform in the government’s energy-permitting process, including small tweaks to the infrastructure-permitting process and approval of the Mountain Valley Pipeline project. This could set the stage for a more substantial bipartisan bill down the road. A regulatory provision that requires budgetary offsets for the costs of any new regulatory proposals. Details around this component are still emerging. On paper it could represent a meaningful change to the process for introducing regulation, but there are a number of factors that could temper the extent to which it limits future regulation.
• Modest expansions to work requirements in the Supplemental Nutrition Assistance Program (SNAP) and the Temporary Assistance for Needy Families (TANF) programs — though Medicaid requirements were left untouched.
• An end to student loan forbearance in August through September, with payments likely to start up again in October.

What’s Next

Today: The House Rules Committee meets to vote on the bill. The committee, which controls the debate on the House floor, is a 13-member panel with four Democrats and who we believe are three “hardline” Republicans: Chip Roy of Texas, Ralph Norman of South Carolina and Thomas Massie of Kentucky. Roy and Norman have already come out against the deal. If all four Democrats vote no (which we don’t think will be the case given Biden’s blessing), then just one more Republican would need to vote against the deal to reach a majority of seven to defeat the agreement in committee. However, Massie, the third hardline Republican, appears receptive to the debt ceiling agreement. We think it’s very likely that the debt ceiling bill will survive this vote.

Wednesday, May 31: Once through the House Rules Committee, the bill may go to the House floor on Wednesday — possibly for a late-evening vote. Recall that the House Republican’s ability to pass a debt ceiling bill on April 26 is what effectively forced Democrats to the negotiating table. However, we believe the White House negotiation process likely resulted in at least 10 lost House Republican votes, including the four Republican holdouts for the previously passed bill.

From a financial market perspective, we think a bipartisan bill is a positive development. We see it as a moderate bill that neither the far left nor far right like. But we believe it gives confidence to investors that at least in very dire circumstances Congress can rise to the occasion. It appears enough centrist House Democrats will vote for this bill for passage, but there are a few potential complications:

• The Sierra Club has come out in opposition of the bill due to some of the tacked-on energy provisions such as natural gas pipeline approvals.
• Republicans added to the bill stricter language regarding work requirements for the SNAP and TANF programs. We think is a sticking point for many Democrats, though the Biden team negotiated to exempt Medicaid from work requirements and expand the size of the programs.
• The language surrounding the end of student loan forbearance is stricter than expected. Payments likely will restart in October as opposed to being pushed out further, which may lose House Democrat votes.

To garner enough votes in January to become the House leader, McCarthy agreed to make it easier for Republicans to remove him as leader. This could come into play eventually, especially since McCarthy would be breaking a promise that only bills with unanimous Republican support in the House Rules Committee would be brought to the floor. But we don’t believe this is something under consideration before the bill goes to the House floor.

Passage of the bill by the House is the biggest hurdle remaining, but both sides seem to be optimistic they can whip up the necessary votes.

Friday, June 2 and possibly into the weekend: Should the bill get this far, the bill’s journey goes to the U.S. Senate. We think this should be less arduous than the House — though not without its own risks and potential delays. Democrats hold the majority in the Senate, 51–49. However, an attempt at a filibuster — where senators exercise their right to unlimited debate to avoid a vote — would require 60 votes to stop. Republican Senate Minority Leader Mitch McConnell has voiced his support of the bill and we think he will be able to provide Democrat Senate Majority Leader Chuck Schumer with enough votes to squash a filibuster. Schumer on Sunday praised Biden for negotiating a deal and told senators to prepare for a vote late this week. Even with the votes secured, be prepared for a long session with votes on various amendments not likely to pass. Should the bill get this far, we think it’s likely to pass.

What It Means for Investors

While the financial press has been fretting over the debt ceiling for weeks, evidence of significant investor concern has been concentrated in a fairly narrow portion of the market. U.S. equities have been very well behaved, holding onto year-to-date gains while the VIX Index (a measure of implied equity market volatility) has been under 20 since the banking issues began fading in late March. We think this suggests little concern that a disruption from a mishandled debt ceiling would disrupt markets. We did see signs of cautious positioning in short-maturity Treasuries. Investors avoided maturities immediately following the X-date, which resulted annualized yields as high as 200 basis points above the federal funds rate last week for certain maturities in early June. Those yields have largely normalized as of this morning, though maturities immediately following the X-date still trade with modest concessions of about 20 basis points to reflect some residual risk of passage of the extension.

We have also been closely following movements in the federal funds futures market to gauge investor expectations regarding the potential response from the Federal Reserve. As a reminder, this market reflects a probability-weighted distribution of potential outcomes for the Fed as opposed to a “base case” expectation. A month ago, the futures market was pricing 100 basis points of Fed rate cuts by January of 2024. We think this likely reflected concerns of a growing a risk case that the Fed would need to respond aggressively to an economic or financial market dislocation, either from the recent banking sector issues or a failure to raise the debt ceiling, which would more than 100 basis point in cuts. With both downside scenarios now appearing far less likely, the market is only pricing in a cut of 25 basis points by January of 2024. Meanwhile, the futures market is showing a 25 basis point hike is back on the table for June, with better than 50% odds.

From a tactical asset allocation perspective, we have been largely neutral in terms of absolute risk and fairly muted in the active risk we are willing to take in the current environment. A resolution to the debt ceiling crisis has been our base case, and the muted market reaction today suggests the market shared that view. Evading a negative event that investors placed very low odds on does not represent a material positive for the market, but does remove a tail risk.

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See related insights:

How the U.S. Debt Ceiling Crisis May Impact Markets and the Economy (May 25, 2023)

What if the U.S. Defaults? And Other Debt Ceiling Scenarios (May 23, 2023)

Quick Q&A: What U.S. Debt Ceiling Tension Means for Money Markets and Investors (May 19, 2023)

Debt Ceiling: High Risk, Low Reward (May 12, 2023)

The X Factor: Evaluating the U.S. Debt Ceiling (January 30, 2023)

The U.S. Debt Ceiling Clock Has Started (January 23, 2023)

Debt Ceiling Drama (January 20, 2023)