
How the US Debt Ceiling Crisis May Impact Markets and the Economy
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.
See our latest insights and research.
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)
IMPORTANT INFORMATION. For Asia-Pacific markets, this information is directed to institutional, professional and wholesale clients or investors only and should not be relied upon by retail clients or investors. The information is not intended for distribution or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation. Northern Trust and its affiliates may have positions in and may effect transactions in the markets, contracts and related investments different than described in this information. This information is obtained from sources believed to be reliable, and its accuracy and completeness are not guaranteed. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice and does not take into account all the circumstances of each investor. Opinions and forecasts discussed are those of the author, do not necessarily reflect the views of Northern Trust and are subject to change without notice.
This report is provided for informational purposes only and is not intended to be, and should not be construed as, an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice or tax advice. Recipients should not rely upon this information as a substitute for obtaining specific legal or tax advice from their own professional legal or tax advisors. Information is subject to change based on market or other conditions.
Forward-looking statements and assumptions are Northern Trust’s current estimates or expectations of future events or future results based upon proprietary research and should not be construed as an estimate or promise of results that a portfolio may achieve. Actual results could differ materially from the results indicated by this information.
Past performance is no guarantee of future results. Performance returns and the principal value of an investment will fluctuate. Performance returns contained herein are subject to revision by Northern Trust. Comparative indices shown are provided as an indication of the performance of a particular segment of the capital markets and/or alternative strategies in general. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index. Net performance returns are reduced by investment management fees and other expenses relating to the management of the account. Gross performance returns contained herein include reinvestment of dividends and other earnings, transaction costs, and all fees and expenses other than investment management fees, unless indicated otherwise. For additional information on fees, please refer to Part 2a of the Form ADV or consult a Northern Trust representative.
All securities investing and trading activities risk the loss of capital. Each portfolio is subject to substantial risks including market risks, strategy risks, adviser risk and risks with respect to its investment in other structures. There can be no assurance that any portfolio investment objectives will be achieved, or that any investment will achieve profits or avoid incurring substantial losses. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Risk controls and models do not promise any level of performance or guarantee against loss of principal. Any discussion of risk management is intended to describe Northern Trust’s efforts to monitor and manage risk but does not imply low risk.
Northern Trust Asset Management is composed of Northern Trust Investments, Inc. Northern Trust Global Investments Limited, Northern Trust Fund Managers (Ireland) Limited, Northern Trust Global Investments Japan, K.K, NT Global Advisors, Inc., 50 South Capital Advisors, LLC, Northern Trust Asset Management Australia Pty Ltd, and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.
© 2023 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A.
P-052523–2924626–052424