As the US government's deadline to raise the debt ceiling approaches, the debate in Congress is intensifying.
In order to meet its obligations, the government needs to agree on a bipartisan solution to increase the nation's debt limit, which controls how much money it can borrow. The longer it takes to reach an agreement, the greater the potential for stress in financial markets. Although there are several ways to raise the debt limit, some are straightforward but unlikely, while others are more challenging and, in the worst-case scenario, could cause significant economic and market stress.
Ultimately, we believe a resolution can still be reached in the eleventh hour, as it has in the past. At that point, equities should breathe a sigh of relief and refocus on the fundamental outlook – the pace of inflation, direction of interest rates, growth and earnings.
X-date
Since the US reached its debt limit of $31.4 trillion on January 19, the Treasury has been utilizing “extraordinary measures,” or essentially creative accounting, to sustain government operations and meet the country’s financial obligations. However, these measures are finite, and the urgency of the debt limit debate has escalated in the past week as Treasury Secretary Janet Yellen cautioned that the country could exhaust these measures by June 1, which is referred to as the “X-date.”
Shouldn’t They Call It a Debt Escalator instead of a Debt Ceiling?
Since 1917, the US government has raised the debt ceiling over 100 times, with the limit roughly doubling each decade since the 1980s. In the past 12 years alone, Congress has passed legislation to raise or suspend the debt ceiling 7 times, in 2011, 2013, 2017, 2018, 2019, and twice in 2021. However, the process has become increasingly politicized and drawn out, particularly in the last decade as Congress has become more divided.
Previous negotiations over the debt ceiling have been periodically fraught with tension, such as the 2011 and 2013 standoffs that saw a last-minute deal before the Treasury's projected deadline.
In both instances, equities declined in the month leading up to the date the debt ceiling was raised, but then bounced back once a deal was reached.
Stocks fell sharply during the debt-ceiling gridlock of 2011, which came alongside the Eurozone debt crisis. The S&P 500 sold off 17% between late-July and mid-August of 2011. This resulted in substantial equity volatility, with the VIX spiking above 40 and a downgrade of the US credit rating from AAA to AA+.
The October 2013 showdown was less concerning to risk assets: The S&P 500 fell 4% in the month leading up to the date the debt ceiling was raised, but created "temporary dislocations" in the Treasury market, with Treasury bills maturing past the X-date, trading at a steep discount to nearby securities.
The index rose 26% and 19% in the ensuing 12 months in those years.
Since then, the debt ceiling has been raised or suspended without much controversy, and the market has generally treated it as a non-event due to Congress's track record of striking a deal at the last minute.
This time, investors have been particularly concerned about the current debt-ceiling negotiations since Republicans achieved a narrow majority in the House of Representatives last November and have vowed to wring budget concessions from the Democrat Administration in return for a vote to increase or suspend the debt ceiling.
| S&P500 | 10y Treasury (change in yield basis points) | US Dollar index (DXY) | |||||||
| Month leading up to deadline | 3 months post resolution | 12 months post resolution | Month leading up to deadline | 3 months post resolution | 12 months post resolution | Month leading up to deadline | 3 months post resolution | 12 months post resolution | |
| 2011 | -17.2% | 8.2% | 26.2% | -107.8 | -5.8 | -25.7 | -2.6% | 5.5% | 11.4% |
| 2013 | -4.1% | 11.0% | 18.9% | -33.3 | 35.9 | -30.6 | -3.1% | 1.2% | 6.5% |
Source: Refinitiv, Wilsons.
The Sticking Point
Republicans are insisting that any lift in the debt ceiling must come with a promise of spending cuts, aiming to reduce deficit spending by around $4.8 trillion over the next decade. The majority of that reduction comes from a single provision to decrease spending in 2024 by $3 trillion.
On the other hand, Democrats have rejected any spending cuts tied to raising the debt ceiling and are advocating for a "clean" standalone bill to lift the cap. They propose deficit reduction strategies should be discussed as part of separate negotiations on federal funding.
The notion of a spending cap may serve as a basis for the final deal, albeit one that is probably less restrictive than the Republicans' proposal.
Both parties met on May 9 to discuss the matter, but deep disagreements remained, leaving them no closer to a deal than they were when they last met face-to-face in February. The only positive outcome of the meeting was that Congressional leaders agreed "to take default off the table."
Can a Timely Compromise Be Reached?
The debt ceiling issue has several potential outcomes, including a swift consensus agreement, a multi-week political gridlock leading to default, or an extension.
The simplest solution would be to cleanly pass an agreement to raise or suspend the debt limit. If this were to happen, markets would largely ignore the fiscal debate and resume their focus on the pace of inflation, actions of the Federal Reserve and the outlook for growth and earnings.
However, given the current stance of both parties and the impending X-date, this seems unlikely. Failure to reach a timely agreement would increase market volatility and raise concerns about whether a bill would pass Congress in time to avoid default. A threat to credit-worthiness would also increase Treasury interest rates and lower the value of the dollar. However, the traditional safe-haven role of longer-term Treasuries and the dollar make this effect less certain.
Delaying the Decision
The current impasse has increased the likelihood of a short-term extension of the debt limit, possibly until the end of the fiscal year in September, which would align the default and shutdown deadlines and enable both issues to be addressed simultaneously. Time is running out and the odds of a temporary reprieve are growing as the tentative X-date approaches. However, an extension would merely defer the debate over the debt ceiling, and if postponed long enough, it could coincide with the beginning of the 2024 presidential election cycle - not ideal for either party.
Volatility on the Cards
We are already seeing implications in the short end of the Treasury yield curve where very short-dated Treasuries are selling at depressed prices as investors are reluctant to take the chance of non-payment.
Treasury volatility as measured by the MOVE index, although lower than the Silicon Valley Bank-induced peak, remains extremely elevated relative to history.
It should be recognized that this situation will, eventually, be resolved. While the polarized Congress could push the government to the brink of default, neither party would want to be responsible for a fiscal crisis. The maximum leverage for both sides is on the deadline, and that is why the deal probably gets done at that point. Nonetheless, the exact X-date is still somewhat fluid.
The ongoing debate is likely to produce near-term market volatility with the potential risk of a significant risk-off phase, similar to what was experienced in 2011 and 2013 when lawmakers allowed the debate to go down to the wire.
Ultimately, we believe a resolution can still be reached in the eleventh hour, as it has in the past. At that point, equities should breathe a sigh of relief and refocus on the fundamental outlook for inflation, direction of interest rates, growth and earnings. Investors should be prepared for near-term volatility, but recognize the issue is unlikely to be a key determinant of market performance over the coming year. The debt ceiling is sitting alongside strains in the US banking sector as a reason to have some tactical caution. However, this is balanced against the prospect of falling inflation, the end of the Fed tightening cycle and a still seemingly resilient US economy. We maintain a relatively neutral allocation to global equities, with a preference to emerging markets.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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