Global Weekly Commentary: Debt ceiling showdown redux
Our pro-risk stance
We remain pro-risk and opt to look through any short-lived volatility that could result from a battle over lifting the U.S. debt limit and funding the government.
U.S. consumer price increases slowed in August, but inflation pressure has broadened to core items less affected by the pandemic.
Several central bank policy meetings are in focus. We don’t expect growing inflation pressure to lead to an earlier rate liftoff by the Federal Reserve.
The U.S. needs to soon raise a self-imposed federal debt limit, or the “debt ceiling”, to avoid a debt default. We don’t see fundamental risks from the debt ceiling showdown – with a low risk of technical default and limited chance of a temporary government shutdown. Yet the twists and turns could trigger jitters in markets that have had an extended run higher. Still, we favor looking through any volatility and stay pro-risk over the next six to 12 months.
Calm before the storm?
Changes in 4-week Treasury Bill yields during debt ceiling episodes
Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, September 2021. Notes: The chart shows changes in yields of 4-week Treasury Bill (T-Bill) yields from 28 days before the debt ceiling “deadlines”, or the dates when the federal government exhausts its borrowing in selected debt ceiling episodes. These deadlines are August 2, 2011, Oct. 17, 2013, Sept. 29, 2017. We use Oct. 15 as the projected debt ceiling “deadline” for this year.
The Congress has acted to adjust the debt ceiling 78 times since 1960, according the Treasury Department. Over recent decades the debt ceiling has become a subject of intense partisan wrangling. A two-year debt ceiling suspension expired in July, and the Treasury Department said its “extraordinary measures”, or maneuvers to manage cash and debt in order to avoid breaching the debt limit, could run out next month if Congress doesn’t act. So far we have only seen modest movements at the front end of the Treasury yield curve – in line with market reaction ahead of recent debt ceiling deadlines with the exception of 2017. See the chart above. We see today’s unique market dynamics as contributing to the muted signal from the Treasury market. The Federal Reserve’s near-zero policy rate has intensified the hunt for yield, just as the central bank has become a large buyer of Treasuries. In addition, banking regulations since 2008 have helped broaden the buyer base for Treasuries.
Today’s macro environment is very different from previous debt ceiling episodes over the past decade. An economic restart is underway in the U.S., and inflation pressure has increased amid pandemic-related supply disruptions. We uphold our tactical pro-risk stance as the restart broadens out, and what we call the new nominal – a more muted reaction from central banks to higher inflation than in the past – is also supportive of risk assets. This is in contrast with the debt ceiling showdown in 2011 that triggered a downgrade in the United States’ AAA sovereign credit rating by S&P just as the euro area debt crisis and worries about slower growth kept investors on their toes. It also differs from 2018, when worries about U.S.-China trade tensions and their impact on the economy were flaring up.
How will the debt ceiling showdown affect the prospects of Congressional spending plans? We believe it will unlikely derail the $1 trillion bipartisan infrastructure bill or the Democrats’ proposed $3.5 trillion spending plan on social policy and climate change - key legislative priorities ahead of the 2022 midterm elections. Yet we do expect the $3.5 trillion price tag on the Democratic-sponsored reconciliation package to be scaled down to help ensure the support of party moderates, who have balked at some of the proposed tax increases for corporates and high-earning individuals to offset spending.
We believe Congress will ultimately reach an agreement to raise or extend the debt limit, but likely not until right before the Treasury exhausts its borrowing capacity. That may come in late October or early November, but the timing is hard to estimate due to lumpy Treasury cash flows for Covid relief payments. The good news: Neither political party wants to see a technical default, and there are no calls for substantive spending cuts. Hence we do not believe the debt ceiling represents a fundamental risk to the market. The risk: The timeline to resolve the debt ceiling is tight. Political brinksmanship appears likely, and any miscalculation could lead to a short-lived government shutdown that triggers market volatility.
Bottom line: We expect Congress to ultimately reach an agreement on the debt ceiling, and see the odds of the federal government committing technical default –or violating terms of its debt - as low. Risk assets could suffer temporary pullbacks after an extended run higher, but we favor looking through any volatility and staying pro risk over the next six to 12 months. We recently downgraded U.S. equities to neutral on a tactical basis to fund an upgrade to European equities, as we see the baton of global restart being passed on to Europe from the U.S.; we remain underweight U.S. government bonds.
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