Debt Ceiling Crisis Averted?

The short answer is not yet. Saturday evening, U.S. President Joe Biden and Republican speaker Kevin McCarthy agreed to a tentative deal to suspend the U.S. government's debt ceiling of USD 31.4 trillion. This comes as an end to a protracted stalemate. However, bipartisan support is necessary for the bill to get the green light from Congress.

The debt ceiling, first introduced in 1917, denotes the borrowing limit authorized by Congress for the government. While this limit has seen a total of 78 hikes since 1960, in recent decades it has become a point of contention in fiscal policy discussions. This contention has led to two partial government shutdowns in 2013 and 2018-19.

When the U.S. reached its debt ceiling on January 19, 2023, Treasury Secretary Janet Yellen began implementing temporary "extraordinary measures". On May 1, 2023, she expressed that these measures might run out as early as June 1, 2023, it was later extended to June 5. The debt ceiling has been raised multiple times since the 2013 deadlock, without any budgetary conditions. However, the latest standoff in 2023 saw Republicans proposing spending cuts as a condition for raising the debt ceiling. Democrats, on the other hand, sought a "clean raise" without preconditions, as was the case during the Trump administration's three debt ceiling raises amid the Covid-19 pandemic.

Over the past decade, Republicans have leveraged the need to raise the debt limit to push for budget cuts. In contrast, Democrats have refused to concede, challenging Republicans to induce a U.S. government default.

What’s in the current deal?

As we write, details of the deal filtered through the media involve suspending the debt limit until January 2025, setting spending caps for the 2024 and 2025 budgets, reclaiming unused COVID funds, expediting some energy project permits, and introducing additional work requirements for food aid programs. Non-defense discretionary spending will be capped at 2023 levels for one year and increased by 1% in 2025. The deal contour will become clearer in the following days as the bill is released and passed to the House Representatives for reading.

What’s in the deal matters

The bill's content is crucial. It determines whether it can pass swiftly through the legislative chambers, or if it must be revised. Early indications suggest spending cuts are limited, which could face harsh opposition from the Republicans given that the bill passed in late April implied a USD 4.8bn deficit reduction over the next decade. Some Republican representatives, such as Dan Bishop and Bob Good, have already expressed their dissatisfaction, arguing it is a total surrender.

Next, the specifics of the spending caps could affect U.S. growth prospects. Man Group notes that equities sensitive to government spendings, such as healthcare and industrials, could suffer if budgetary constraints are too strong.

The voting parkour

Getting the bill through the House could be difficult. Kevin McCarthy has less control over his caucus compared to his predecessors. It took a historic fifteen rounds of votes to be elected House Speaker in January. This is partly why Aegon AM believes the chances of some form of selective default by the U.S. government are higher now than on previous occasions (33-50%).

Passing the bill in the House requires a simple majority - at least 218 votes - and bipartisan support, as some extreme Republicans and Democrats may vote no. Some representatives may also be absent. Debate and passage in the House could take a day or two.

In the Senate, where Democrats hold a 51-49 majority over Republicans, at least nine Republican votes are needed to pass the bill due to the "filibuster" rule. Individual senators can slow the process by insisting on procedural maneuvers. Importantly, the Senate must pass the bill without changes to the House version, or it will have to be voted on again in the House.

What if the bill is delayed or sent back to the drawing board?

Congress might agree to a short-term extension of the debt ceiling. Most investment managers believe the chances of a technical default are slim. However, SSGA points out that rating agencies may issue a credit watch, as Fitch did on May 24th, or even a downgrade, which could trigger a series of negative reactions.

Hitting the debt ceiling doesn't stop all government functions. Instead, it limits Washington's ability to spend beyond its revenue. When this happens, the government prioritizes essential spending and may cut less important costs. The U.S. Treasury could stop non-debt-related payments. This means social security benefits, Medicare/Medicaid payments, wages to government workers, tax refunds, and payments to government contractors could be put on hold. The government may also pause many services, like national parks and monuments. Some government employees may be forced to take leave. During the 2013 and 2018 shutdowns, around 800,000 employees were furloughed.

What if a technical default happens?

TCW Group suggests that if a technical default happens, treasury issuances can't be transferred. The maturity dates of these issuances also can't be changed. When a solution is found, the original security holder will get their principal and interest payments on the due date. The Treasury has the option to delay these payments by extending the maturity date. Even with extended maturity dates, securities can be traded and transferred.

Capital Group and Fisher Investment anticipate swift market volatility if a technical default occurs. Capital Group expects Congress to act quickly and raise the debt limit. Yet, rating downgrades, which could increase the cost of U.S. borrowings and lower investor confidence in U.S. treasuries, are likely. These downgrades could have unpredictable effects on banks, insurance companies, and federal agencies whose ratings tie to U.S. sovereign ratings.

Invesco predicts that, as in 2011, riskier assets like emerging markets and U.S. small-cap stocks could face market volatility. SSGA adds that rapid changes in short-term rates and sharp declines in risky assets like equities and commodities could occur.

TCW Group points out potential issues with money market funds. If a default happens, these funds could prevent redemptions or charge fees for them, leading to large investor outflows. But panic should be temporary because of strict regulations and access to the Fed's reverse repo facility. They also anticipate the Fed creating a liquidity facility to buy defaulted treasuries.