With U.S. Treasury Secretary Janet Yellen reiterating that the government may run out of funds as early as next week without a debt ceiling deal, the chance of the first-ever U.S. default remains alive. If the government prioritizes its debt obligations over other non-debt obligations to avoid default, we expect market volatility and a potential government shutdown that could put a drag on the economy. But a short-lived crisis may create opportunity for investors.

The Timing of the X-Date

In April, the U.S. House of Representatives passed their proposal to raise the debt limit that included $4 trillion in government spending cuts over 10 years. The bill stands little chance of passing through a Democratic-controlled Senate, but it did spark the negotiations that are continuing to this day. With lower tax revenue in April, Yellen is saying the date the government may run out of money, the so-called X-date, is as early as June 1.

Revenue and outflows are variable, so it is conceivable that the Treasury’s estimate is early. Tax receipts in mid-June could extend the X-date if the Treasury’s cash balance can linger above zero until then (see Exhibit 1). But it is also conceivable that funds run out before then and that June 1 could indeed be the true X-date.

Even if an agreement is not made prior to the X-date, the government could prioritize paying interest and principal to help mitigate the consequences until an influx of new cash arrives in mid-June from quarterly tax receipts. In other words, payment prioritization could end up lasting only a short period until new revenue helps establish a later X-date, potentially some time toward late July or August with help from a new extraordinary measure that is expected to become available in late June.

Potential Paths from Here

While negotiations are coming down to the wire, we remain cautiously optimistic that the debt ceiling will be resolved by the X-date. While both parties have competing preferences, they share a similar constraint in that a technical default, where the government violates some but not all debt obligations, is highly likely to trigger undesirable consequences. On the positive side, both parties could agree to extend the debt ceiling beyond the 2024 election or a short-term extension. On the negative side, with no deal the government may breach the debt ceiling but prioritize debt obligations while delaying other non-debt payments. Or the U.S. could enter default by halting payments on debt and principal.

The Potential Impact on the Economy and Markets

We think a prioritization of payments would spark market volatility. As investors remain on edge wondering if a deal will ever surface, we believe financial market volatility would be meaningfully elevated. And it is conceivable that equities could experience declines similar to or greater than the 2011 debt ceiling episode when they fell around 17% (see Exhibit 2) after Standard & Poor’s downgraded its rating on U.S. debt.

In the bond market, we think the yield curve would invert further with shorter-maturity yields garnering little interest but long-end yields declining so long as investors maintain trust in the U.S. to service its debt longer term. This was the experience during the 2011 episode, and what we would expect this time around as well. Even in a U.S. debt crisis, investors could still see Treasurys as safe haven assets. But they may also more closely scrutinize the safe-haven nature of U.S. debt given a significantly higher debt load of about $25 trillion today versus $10 trillion in 2011.

Investors would enter uncharted territory in the case of total default. While we view this as an unlikely outcome, in our money market funds we have avoided adding debt maturing during the June-to-August “X-date window” when a default would be most likely to occur. But otherwise, financial markets rely heavily on Treasury debt because historically their yields represent the “risk-free rate”, based on the assumption that the U.S. government won’t default, used to value assets (and Treasurys often are used as collateral). A risk-free rate that isn’t risk-free any longer likely introduces a lot of trouble into the markets.

With the economy, the damage would likely grow in severity the longer it takes to strike a deal. If a stalemate leads to a government shutdown, we think ramifications including furloughs of government workers would appear quickly. The shutdown of October 2013 had wide-ranging consequences. From the closure of national parks to delayed food safety inspection, the loss of government workers slowed the economy. Standard & Poor’s tallied the damage at 0.6% loss of gross domestic product.

An Eye on Opportunity

Ultimately, however, we expect most of these impacts would be short-lived. In fact, if it appears that the U.S. government will indeed be able to maintain its credibility on a global scale, any outsized market pullback may prove to be a buying opportunity. Assuming longer term impacts on interest rates and dollar strength are inconsequential, we could be left with a backdrop of more attractive equity valuations and a more risk-friendly Federal Reserve cautious not to trigger and/or exacerbate any unintended consequences. With that said, much of the risk-reward balance under this scenario would depend on the way in which negotiations progress.

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See related insights:

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)