Congress Plays Chicken as the Debt Ceiling Looms

Summary

• Congress must avert a government shutdown by 30 September and raise the debt ceiling before it runs out of money in October. The House has passed a bill addressing both issues.
• Republicans say they support both measures but insist on separating them so Democrats take sole responsibility for raising the debt ceiling.
• If Democrats acquiesce, they risk losing control of Biden’s signature $3.5tn social and infrastructure plan.
• Markets seem confident that both issues will be resolved but the situation may be more fraught than investors assume.
• The debt ceiling debate could go to the wire – and markets may have to take Congress out to the proverbial woodshed before it is resolved.

Market Implications

• Position for volatility and a possible sharp selloff if the debt ceiling deadline approaches with no resolution in sight.
• Buy index puts or short index ETFs.
• Treasuries and bonds will sell off.

Congress faces two pressing deadlines in coming weeks. First is passing a continuing budget resolution to keep the government open after 30 September. And second is to raise or suspend the debt ceiling before the Treasury runs out of money sometime in October. If they cannot, the US risks defaulting on its debt obligations.

Neither prospect seems to bother markets. An overwhelming consensus agrees Democrats control Congress and the White House, and they will act to avert the crisis. My colleague Dominique Dwor-Frecaut makes this case in her weekly discussion.

But a more fraught (if still low-probability) scenario is in play, too.

Where Things Stand Now

The House of Representatives has passed a bill addressing both issues.

This bill requires 60 votes to pass in the Senate, but Senate Republicans plan to filibuster it. They say they support both legs – passing a continuing resolution and raising the debt ceiling – but want to separate them.

They want to vote on (and pass) a continuing resolution bill and avert a government shutdown. And they want the Democrats to fold the debt ceiling legislation into their partisan $3.5tn social and infrastructure plan and pass it through a budget reconciliation process not subject to the filibuster.

That way, no Republican need go on record as supporting lifting the debt ceiling. They hope to make their newfound fiscal rectitude a campaign issue in the 2022 midterm elections.

Speaker Nancy Pelosi has said she wants to avoid a government shutdown. Presumably, a clean continuing resolution bill will pass both houses in coming days and be signed into law.

Building a Better Mousetrap

Were resolving the debt ceiling that simple, Democrats would probably acquiesce. But it is not, and Republicans hope to mousetrap Democrats along these lines.

In reality, the Democrats cannot simply add debt ceiling language to their partisan infrastructure and social welfare bill. Rather, it will have to return to the House Budget Committee for amendment, then go through successive votes to gain full House approval before submittal to the Senate. And then the Senate must go through a similar process. (In a Budget Committee vote last night, Democrats declined to include debt ceiling language in the bill, signalling they plan to defy Republican pressure.)

At the very best, this process could take weeks, leading to delays in passing the legislation. It could also delay the House from voting on the bipartisan $1tn infrastructure bill that has already passed the Senate. House progressive Democrats so far have said they won’t vote for it without assurances that their partisan $3.5 tn bill will also pass the House and Senate. Those delays will subsequently mean that, come the midterms, voters will have seen less rather than more of the benefits that these bills could ultimately deliver. And that will make it all the easier for Republicans to paint the Democrats as inept legislators.

But Senator Mitch McConnell and the Republicans know full well Democrats are hardy united in their support of the partisan $3.5tn social and infrastructure bill. The more likely scenario is that if the bill must go through the committee process again, it will be watered down – perhaps to the point where more progressive representatives refuse to support it, and it effectively dies.

With time of the essence, House Democrats would have little choice but to pass a clean debt ceiling bill that could pass the Senate through the reconciliation process, which is not subject to a Republican filibuster. They then could not pass another infrastructure bill through reconciliation this year.

That, in a nutshell, is McConnell’s plan to gut, if not crush, President Joe Biden’s infrastructure and social welfare agenda.

How Will Things Play Out?

If we take Pelosi at her word, a government shutdown will not happen. But even if it does, markets will likely shrug it off. By now, this script is a known-known.

The debt ceiling is another matter. Democrats have much at stake. If they can amend the $3.5tn bill without other major changes, it will most likely sail through the reconciliation process albeit perhaps uncomfortably close to the deadline. That is the base case.

But there is also risk that an amended infrastructure bill does not make it through the House, leaving only the debt ceiling legislation. That in turn risks upsetting progressive Democrat Senators. As long as Republicans remain united in their refusal to back raising the debt ceiling it will take only one Democrat Senator to scuttle a reconciliation bill.

Whether the debt ceiling is resolved through bipartisan approval or reconciliation may depend largely on messaging by Democrats and Republicans over who is to blame for the looming crisis, and to which side the public chooses to listen. While Republicans may be largely culpable for are for the current debt mess, Democrats are extraordinarily bad at the messaging game.

This one could go to the wire.

Investors, Beware!

Markets may remain blasé about the debt ceiling for weeks as Republicans and Democrats fight their war of words. But if the deadline approaches with no resolution in sight, we anticipate rising volatility. It may take a major market selloff to goad Congress into somehow raising the debt ceiling.

We recommend investors buy index puts and short index ETFs as a hedge against this volatility.

Treasury securities and corporate bonds will also be subject to a sharp selloff.

Alternatively any major selloff should provide an attractive opportunity to put cash to work.