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Debt ceiling scenarios

I rarely find political prognostication to be a fruitful exercise. Politics are mostly noise for markets. But, in this case, the debt ceiling negotiations in Washington, D.C., are already creating market volatility and have the potential to do real damage. It’s hard to ignore. In this article, we will briefly detail the new developments since Erik Ristuben’s report a week ago. And then we will walk through the scenarios of what could happen—ranging from the best case (a prompt deal) to the worst case (a prolonged impasse).

What’s new?

U.S. Treasury Secretary Janet Yellen reaffirmed that the Treasury Department is likely to run out of money in early June. We still don’t have a deal to raise the debt ceiling. There is not much time left. But the politicians are now actively negotiating. That’s good news. At the risk of listening to what a politician says, public statements from President Joe Biden and House Speaker Kevin McCarthy on Wednesday and Thursday genuinely sounded more upbeat, indicating a deal could be reached as early as this weekend and taken to a vote next week. Headlines were more downbeat Friday morning with Republicans citing the White House demands as “unreasonable.” Just remember, as Yogi Berra once said, it ain’t over til it’s over. I will sleep better when a debt ceiling bill passes the House.

Scenarios

Deal. If both parties can promptly agree to raise the debt limit, then 2023 will just be another line item in a growing list of major and minor debt ceiling scares (2021, 2013, 2011, 1995). Financial markets are likely to show a moderate relief rally—similar to the 1% gains realized on the S&P 500 Index during Wednesday and Thursday’s trading sessions. Yields on Treasury bills maturing in early June—which were trading more than 50 basis points above overnight indexed swaps earlier this week—are likely to decline as default risk is taken out of the yield curve. Longer-term Treasury yields might initially rise in sympathy with improving investor confidence, but any sustained moves in bonds will require a careful look at the details of the deal. If the deal includes meaningful fiscal restraint (e.g., multi-year discretionary spending caps) those policies would—all else equal—dampen economic growth and inflation and be bullish for bonds.

Expectations are that a bipartisan deal would make the debt ceiling a non-issue until 2025 (after the next U.S. elections).

Punt. Given June 1 is only two weeks away, it is possible that politicians, negotiating in good faith, simply do not have enough time to draft and sign a bill before the Treasury runs out of money. In such a scenario Congress could choose to extend the debt ceiling for a period, perhaps to late July / early August. Market direction would hinge on perceived progress (or lack thereof). Yields on Treasury bills maturing in early June would decline, similar to the deal scenario. But instead of default and illiquidity risk getting taken out of the curve, it would simply be pushed out to the new drop-dead-date. Rinse and repeat.

A brief impasse / the mistake. It is possible that negotiations break down for a range of reasons. It is also conceivable that Congress and the White House agree in principle to the terms of a debt ceiling package. Former President Donald Trump (who has already weighed in) might then opine the package does not go far enough on spending cuts and then call on House Republicans to vote against the bill. Given the time crunch, a failed vote (a mistake) could create real challenges, too. A failure, regardless of the cause, while unlikely, would be a serious event for financial markets.

Markets do not like uncertainty and would very likely sell off in this scenario. I’ll describe the potential damages in detail in the next section. Here, I’d like to stress why any impasse is likely to be brief and could potentially create opportunities for tactical investors to take advantage of the dislocation in asset prices.

Markets are a forcing mechanism. Let’s go back to the fall of 2008. I’m a junior Fed staffer in D.C. I don’t have any gray hair yet. More importantly, the Emergency Economic Stabilization Act of 2008 comes up for a vote in the House on Sept. 29. $700 billion for the Troubled Asset Relief Program (TARP) is on the line. The vote fails. The S&P 500 Index craters 8.8% in response to the vote. By Oct. 3—the Friday of that same week—the bill had passed the House and Senate and was signed by President George W Bush. The lesson? Markets punish politicians for making mistakes. It happened in the United States in 2008. It happened in the United Kingdom in 2022. Our baseline would be to expect any volatility to be short-lived.

Prolonged impasse. Let’s end this note with a jump off the deep end. A prolonged impasse would likely inflict severe damage onto the U.S. economy and financial markets through three primary channels

• Delayed government spending. The Congressional Budget Office estimates Treasury faces a shortfall of roughly $450 billion into the end of the current fiscal year on Sept. 30. Delaying these payments would be the equivalent to losing 1.7% of GDP (gross domestic product). That’s already a recessionary impact from these direct effects alone. Unfortunately, it’s likely to be much worse than that.
• Financial markets are likely to sell off. It’s nigh impossible to put precise numbers to this scenario but we would likely see a very sharp drawdown in equity markets and a blowout in credit spreads. For example, in its contingency planning for the 2013 debt ceiling standoff, the Federal Reserve staff estimated a one-month debt ceiling impasse would result in U.S. BBB credit spreads widening by 150 basis points. All of this would make it harder for households and businesses to access credit, contributing to a sharp slowdown in activity. The dollar would likely weaken against other safe haven currencies. And market effects would likely be felt globally, given the still dominant role that the U.S. economy plays in the global financial system.
• Consumer and business confidence would likely evaporate, delaying major purchase decisions and capital expenditures until Washington, D.C., got its act together.

In an impasse scenario, government agencies like the Federal Reserve and U.S. Treasury would try to slow the bleeding. The details of these agency responses are likely to be critical for markets, particularly sovereign bonds. Staff level discussions between the Federal Reserve and U.S. Treasury in 2011 and 2013 suggest Treasury was planning to prioritize principal and interest payments in the event of a debt ceiling impasse. If they did this—which is our expectation—bond holders would be made whole. That’s obviously a critically important detail for a fixed income investor.

Summary

We have not made any material changes to our portfolio strategy in advance of the debt ceiling event. We are generally emphasizing security selection with an eye toward carefully managing the overall risk and liquidity profile of portfolios for our clients. The negotiations in Washington, D.C., might trend in a more favorable direction. If that changes, we will be on the lookout for opportunities as market volatility increases in the weeks ahead.

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