Quick Q&A: What US Debt Ceiling Tension Means for Money Markets and Investors
U.S. Treasury Secretary Janet Yellen sent a letter to Congress on May 1 stating that the X-date, which is when the U.S. is projected to run out of funds and potentially default on its debt, may come as early as June 1 unless Congress raises the debt ceiling. This is sooner than many had anticipated and we’ve seen some market reaction as political meetings only recently started. We answer key questions investors may have.
What is the debt ceiling?
The debt ceiling, or debt limit, is the amount of money that the U.S. government is authorized to borrow to meet its existing legal obligations such as, but not limited to, Social Security and Medicare benefits, military salaries, tax refunds and other payments. The debt limit does not authorize new spending commitments. It simply allows the government to finance existing legal obligations.
The debt ceiling was raised by $2.5 trillion in December 2021 to $31.4 trillion. This lasted until January 19, 2023. Since exceeding the debt limit, the U.S. government has been operating under what it calls extraordinary measures to continue funding government operations. Extraordinary measures are accounting maneuvers on the government’s books and records that have little to no impact on fiscal policy or economic growth. The use of extraordinary measures is part of the Treasury department’s “playbook” for debt ceiling episodes. They allow for issuance to continue but can only create a finite amount of capacity that will eventually be exhausted.
What is the likelihood of a U.S. government default?
We view the risk of default as very low. However, no deal has been reached on the debt ceiling as of May 19. Congress must act on the debt ceiling (raising it or suspending it further) to avoid exhausting extraordinary measures. The U.S. has never defaulted on its debt and the market is clearly watching closely. President Joe Biden and congressional leaders have been meeting to discuss the issue and stated that negotiations are ongoing. While they may resolve the issue, Congress could also grant a short-term extension, which has been done before. This would merely delay rather than resolve the debt ceiling issue.
What has occurred during previous debt ceiling crises?
The debt limit originated over 105 years ago and Congress has since acted on it about 100 times. But while acting on the debt ceiling was once a somewhat straightforward formality, it has proven an increasingly tough task over the past decade-plus. Congress has managed to agree on a resolution to avoid U.S. default every time, but a look at several of the most recent impasses reveals it hasn’t always been without near-term pain as Congress often waits until the late when a “crisis” needs attending to:
The 2011 downgrade: In May of 2011, the Treasury began to deploy extraordinary measures and estimated an X-date in August. The split U.S. government struggled to find a resolution as the Republican House demanded a deficit reduction in exchange for a vote to increase the debt ceiling, while Democrats insisted against negotiations on the debt ceiling. In the final days before the X-date, an agreement was made to raise the debt ceiling through a two-stage increase designed to cut spending over the long run. A default was avoided, but Standard & Poor’s cut the long-term U.S. debt rating from AAA to AA+ on August 5, citing concern on U.S. policymaking.
The 2013 impasse: In May of 2013, the U.S. hit its debt limit and the Congressional Budget Office cited an X-date of sometime late in October. On October 16, a bill was signed that ended a partial government shutdown and also suspended the debt limit until February of 2014. With the 2011 downgrade relatively fresh in minds, this impasse brought a more visible response from the Treasury related to its concern on political brinksmanship and the consequences of default.
The 2014–2019 suspensions: From 2014 to 2019 there were a series of debt limit suspensions. Until 2016, the U.S. operated under a split government (a Democrat president and Republican Congress), but the suspensions generally came about without much difficulty — potentially because of debt ceiling “debate fatigue” from the 2011–2013 episodes.
The 2021 punt: In October of 2021, Congress agreed to a minor raise to the debt limit that the Treasury estimated would fund the government until sometime in December. Shortly ahead of the December X-date, Congress raised the debt limit via a one-time pathway that allowed the Senate to raise it with a simple majority vote. The fairly minor increase merely “punted” the issue — setting the stage for this year’s showdown.
What if the debt ceiling is breached or the U.S. government defaults?
If the debt ceiling is breached, temporary remedies may be available once the debt limit is hit, including prioritization of payments. Under this scenario, principal and coupon payments would continue to be made on time with the Treasury deferring other non-debt obligations. This outcome would very likely introduce greater financial market volatility until a debt ceiling raise is accomplished. It could also lead to further credit downgrades by rating agencies and other economic and financial market consequences that worsen in severity the longer it takes to come to a deal.
We assign a very low probability to an outright default, where the U.S. stops servicing its debt. But it remains a risk in play with potential consequences too severe to ignore. We anticipate that the resulting volatility would quickly lead to passage of a debt-ceiling increase, though the pace of a market recovery would likely depend on investors’ assessment of potential consequences from the default.
What should investors do now?
While keeping in mind that we think default is highly unlikely, we don’t think investors should ignore how this is affecting markets now. In particular, we think investors should pay attention to some recent activity in money markets. It shows how investors are concerned that Treasury bills maturing shortly after the beginning of June could face technical default or delayed repayment of principal if Congress fails to raise or suspend the debt ceiling.
Investors have expressed a wide variety of views on holding Treasury bills in the X-date window, from risk aversion to excitement because of higher yields at some maturities. Higher investor demand for Treasury bills maturing prior to June have led to depressed yields well below the current federal funds target range of 5.00% to 5.25%. Investors active in the X-date range, roughly from June to August, are requiring a yield premium to compensate them from the risk of technical default. The risk of default could lead to further curve inversion as investors rush into longer dated Treasurys.
How have we positioned money market strategies?
We have avoided adding exposure from June through August. The investment team continues to monitor the markets and developing news about the debt ceiling and ensure our U.S. money market strategies continue to have high levels of daily liquidity. While we cannot predict what the result will be, we are hopeful Congress will work through the issues to resolve the debt ceiling by the X-date.
How have we positioned our multi-asset portfolios?
A lack of progress on a debt ceiling deal is a key risk to our tactical outlook, but we ultimately expect near-term volatility to subside as an agreement is worked out. Recognizing opportunities and risks in this market and economic environment, we currently maintain a risk-neutral approach in our multi-asset portfolios. We hold an overweight position in high yield bonds and natural resources and a small overweight to cash. We are underweight U.S. and emerging market equities, as well as investment grade bonds. If volatility increases as events unfold, we may look to take advantage of the opportunities any market dislocation presents.
See our latest insights and research
See our related insights on the debt ceiling:
Debt Ceiling: High Risk, Low Reward (May 12, 2023)
Senior Economist Ryan James Boyle discusses what might follow a technical default.
The X Factor: Evaluating the U.S. Debt Ceiling (January 30, 2023)
Chief Investment Strategist Chris Shipley share a history of the debt ceiling and potential outcomes.
The U.S. Debt Ceiling Clock Has Started (January 23, 2023)
NTAM Chief Investment Officer for Global Fixed Income Thomas Swaney discusses market risks of the debt ceiling.
Debt Ceiling Drama (January 20, 2023)
Chief Economist Carl Tannenbaum shares an economic view of debt ceiling risks.
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