Debt Ceiling Crisis to Get Worse Before It Gets Better

Summary

• Republican and Democrat negotiating positions remain far apart, and a market selloff may be necessary to end the standoff.
• Contingency planning by the Fed and the Treasury, including payment prioritization, could limit the market consequences of passing the X-date (likely in early June).
• A continued standoff would result in deep fiscal consolidation and recession and add to the risk of the administration issuing debt above the limit. This would likely bring a market selloff and standoff resolution.
• The standoff will likely be resolved before it does lasting damage to economy or markets. However, it could cause an expansion in the Fed balance sheet that would add to H2 inflationary pressures.

Market Implications

• A debt ceiling crisis would preclude Fed from hiking in June even though it is justified on economic grounds
• Risk assets would sell off and gold gain, but bonds may benefit little due to the inflationary backdrop and risk of deep political crisis.

Standoff Resolution Could Require Market Selloff

The US hit the debt limit on 19 January. In previous debt ceiling standoffs, typically between a Democratic White House and a split or GOP-controlled Congress, an agreement has been found before the X-date (Table 1). This seems unlikely this time largely because US politics have become more polarized. 

On 27 April, House Republicans passed, by two votes, a bill raising the debt ceiling until March 2024 in exchange for expenditures cuts that would lower the deficit by $4.8tn over 10 years.

On 19 May, President Biden held a first meeting with senior Congressional leaders. A second meeting was on 16 May. In front of the media, both sides have been putting their best foot forward. President Biden is cutting short a trip to Asia; House Speaker McCarthy highlighted that a deal was possible by the weekend.

In reality, the parties remain far apart. The Democrats are discussing a debt ceiling increase until end-2024 in exchange for two years of spending caps; repurposing about $50bn of unspent Covid spending; energy permitting liberalization; and tougher work requirements for federal benefit programs. 

These fall well short of Republican demands. Also, Speaker McCarthy’s ability to broker a compromise is limited by the de facto veto power of the most conservative House Republicans, since the GOP House majority is only five seats. In addition, McCarthy was only elected after 15 rounds of voting and after agreeing to reinstate a rule allowing a single House Member to initiate a vote to oust him. 

Standoff resolution may require a market selloff. A precedent is the 2008 TARP vote: on 29 September 2008, the House voted down the Emergency Economic Stabilization Act of 2008.  Over the following days, the SPX sold off about 10% (Chart 1). The Senate amended and voted in the Act on 1 October, and the House did so on 3 October. The SPX only found a bottom in mid-October. By that time, it had fallen by about 30%.

A market selloff would be much less severe now than in 2008 as the economy is much stronger now. For instance, the selloff that accompanied the 2011 debt ceiling negotiation was ‘only’ about 15%. And there was no market selloff during the 2013 debt ceiling negotiations.

This is the debt ceiling paradox: a market selloff is required for resolution but, because markets expect resolution, no selloff is forthcoming. In this note, I discuss how the paradox could be resolved. 

Crossing X-Date Not the Catastrophe Consensus Predicts

The administration’s negotiating strategy has been to stress the economic and market catastrophe of reaching the X-date without an agreement. For instance, Secretary Yellen has warned that, if Congress did not raise the ceiling, ‘We have to default on some obligation, whether it’s Treasuries or payments to Social Security recipients’.

I think this strategy lacks credibility for two reasons. First, Yellen is conflating default and arrears. Once the US runs out of cash, it will fall in arrears in its debt service payments or other expenditures. Only arrears in its debt service could translate into a debt default, provided for instance that a credit event is declared by ISDA’s Determination Committee.  Arrears to, for example, pensioners or defense contractors, are unlikely to lead to the US being formally and legally declared in default!

Second, contingency planning by the US Treasury and Fed suggests that arrears on debt service would be unlikely. We know from past inquiries from Congressional Republicans that in 2013 if the Treasury had run out of cash it would have prioritized debt service, social security and veterans benefit payments. In addition, the NY Fed has run extensive feasibility studies as well as table-top exercises showing the feasibility of payment prioritization. 

And the Treasury cash inflows provide ample cover for interest expenditures (Table 2).  Provided the Treasury can roll its debts, it will be able to remain current on debt service, even after the X-date is crossed. Debt rollovers are unlikely to turn problematic because of Fed contingency planning. 

Transcripts of Fed meetings around the 2013 debt ceiling standoff show extensive contingency planning. These are likely to consist of outright bond purchases, RP and securities swap as well as enhanced liquidity provision to banks (for details of possible measures, see the October 16 2013 FOMC transcript).   

The scale and success of the Fed market intervention in the early stages of the pandemic suggest the Fed can turn itself into an effective ‘Treasury Dealer of Last Resort’. For instance, in the two months to April 2020, the Fed increased its assets by $2.5tn to $6.7tn (Chart 2). 

A likely scenario is therefore that, a few days before the X-date, the Treasury would announce payments prioritization, and the Fed would announce facilities to support the Treasury and RP markets as well as provide liquidity to banks. 

The initial market reaction is likely to be negative. However, provided the announcements are credible, the selloff could be limited. 

That said, there would be long-term costs to the Treasury and Fed. The Treasury’s credibility would be further undermined since it would be forced to admit that payment prioritization is indeed feasible. During the 2013 debt ceiling standoff, the Obama administration denied prioritization was feasible, only to be found out by subsequent Congressional Republican inquiries  to have misled Congress and the public. These findings could have hardened the Republicans’ stance in the current negotiation.

The Fed could see its inflation-fighting credibility and political independence weakened.    First a large expansion of the Fed balance sheet would run counter to its objectives of inflation stabilization. 

Second, the 2013 transcripts show a strong determination from Fed officials to avoid the TGA turning negative, presumably because this would be an obvious form of monetary funding of the budget deficit. In reality, the mobilization of the Fed balance sheet to support the Treasury market would be monetary financing by another name. 

Third, by allowing its printing presses to validate political dysfunction, the Fed would provide politicians with yet more evidence that it is a readily available source of unconditional cash.

The risk with the Fed and Treasury contingency planning  is that it could limit market downside, allow an extended standoff, and further delay resolution.

That said, an extended standoff would still lead to a selloff.

Extended Standoff to Lead to Deeper Selloff

Even if crossing the x-date brings only a limited risk-off reaction, an extended standoff would eventually bring about a marked selloff. This is because in effect the Treasury would be forced to implement a balanced budget, from currently a deficit representing about 7% of GDP (Chart 3). 

This unprecedented fiscal tightening would come alongside a build-up of Treasury arrears and likely a sharp increase in precautionary savings by households and businesses. The combination of a sharp increase in public and private sector savings would bring about a deep recession. Expectations of such a recession would be enough to trigger a market selloff.

Furthermore, an extended standoff increases the risks that the administration could breach the debt ceiling. Since Calvin Coolidge, no president has won re-election if a recession happened in the two years prior to the elections. 

Rising recession risks would therefore increase the administration’s incentive to issue debt above the ceiling by invoking the 14^th Amendment to the US Constitution stating that ‘The validity of the public debt of the United States shall not be questioned.’ The administration has increasingly alluded to this possibility.

Regardless of whether the administration would succeed in this endeavor, it would plunge the country in a deep political crisis. Constitutional scholars are divided on whether the 14^th Amendment allows the president to borrow in excess of the debt ceiling (here are examples of pro and con opinions). 

Congressional Republicans would likely appeal to the Supreme Court, which could take time to decide whether to take on the case – some experts argue it would not. The uncertainty could be so extreme as to cast doubt on the solvency of the US and disrupt Treasury market functioning. This could lead to a selloff deep enough to force a compromise between the White House and Congressional Republicans.

X-Date Likely First Week of June

When are the selloffs likely to happen? There is unusual uncertainty on the X-date. In April, non-withheld Individual Income Tax payments came in $250bn below the CBO expectations (CBO, Treasury Warn X-Day Could Be in Early June). For all its 275 professionals, the CBO could not come up with a full answer for the revenue shortfall and conceded that the uncertainty around its forecast was twice as high as usual.

My best guess is that the shortfall mostly reflects unusually large tax relief granted in response to ‘unusually extreme’ weather events. Taxpayers in 10 states accounting for more than one third of all federal tax receipts have benefitted from a postponement of filing and payment deadlines from mid-April to mid-October.  

Both Treasury and CBO expect the X-date to be in early June, and I agree based on recent patterns of TGA (Treasury General Account, the Treasury cash balance at the Fed) flows as well as the Treasury’s currently planned extraordinary measures (Chart 4). For details, please see our Debt Ceiling Updates.

Market Consequences

A debt ceiling crisis around the Fed’s 14 June meeting would likely see the Fed stay on hold, even if a hike was warranted by economic data (FOMC Review – No Pause After All?).

As discussed above, going through the X-date and a continued standoff are likely to involve risk-off market moves. That is, a selloff in equities, commodities, and EMs as well as a rally in gold. What happens to bonds this time could be different from 2011, when bond yields fell.  This time, bond yields may not fall much or could even rise, for two reasons.

First, the 2011 macro backdrop was one of low inflation; this time around inflation is high.  Because bonds and stocks respond in the same direction to inflation shocks but in opposite direction to growth shocks, the bond-stock correlation tends to be positive when inflation is high and negative when inflation is low (Public Debt Dynamics To Worsen).

Second, as the standoff keeps going, market selloffs are likely to worsen. Eventually, if the standoff blows out in a major political crisis, markets could question the credit of the United States and spark a bond selloff. This is not my base case as I believe neither Democrats nor Republicans have the stomach for it.

I think this discussion implies that the debt ceiling standoff is likely to get resolved fast enough to avoid any lasting damage to economy or markets. This is because markets adjust faster than the real economy and are forward looking.

At the same time, if the standoff brings about a large expansion of the Fed balance sheet without causing lasting damage to the economy, it could add to inflationary pressures in H2.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed, the IMF, and the World Bank. She joined Macro Hive soon after its inception.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)