By Thomas Urano, Co-Chief Investment Officer
The debt ceiling has a long and turbulent history.
The US debt ceiling was established in 1917 through the Second Liberty Bond Act. As it turns out, modifying the debt ceiling is more of a forced negotiation tool rather than an actual long term economic constraint. In fact, legislators have seen fit to suspend or raise the debt ceiling on more than 90 occasions in its 106 years of existence.
Debt ceiling debates occur with reasonable frequency and usually with little fan fair. However, from time to time the political mudslinging gins up fear of default by the US Treasury. Most famously, the 2011 debt ceiling debate resulted in yet another increase in total debt; however, it was accompanied by S&P downgrading US Treasury debt from AAA to AA+. Empirically the debt limit has produced limited fiscal impact and appears to only damage the credibility of US lawmakers.
Where do we stand now?
Discussions of the “X-date,” or when the Treasury will run out of money, is the hot topic. The “X-date” is the day of reckoning – the day where the Treasury officially runs out of money to conduct government operations and maintain timely Treasury interest and principal payments. The variability of tax receipts and timing of spending outlays makes an actual date hard to pin down. Early estimates of a September deadline have been moved up to mid-summer, when lawmakers will start feeling the heat, no pun intended.
What happens if no agreement is reached?
In a no-deal scenario, we believe the Treasury would follow a contingency plan similar to the 2011 playbook. This would include the principal and interest of Treasury securities continuing to be made on time, while delaying other federal government payments. Under this plan, the Treasury will continue making timely payments to bond holders and also conduct new issue auctions to replace maturing securities (thereby not increasing the US debt stock). Meanwhile, a government shutdown would occur, forcing the Treasury to delay payments to all other obligations (agencies, contractors, Social Security beneficiaries, and Medicare providers). This plan should provide enough of a time frame for Congress to build a consensus.
Is the debt ceiling impacting markets?
Despite a 100% historical hit rate on raising the debt ceiling, investors are nonetheless concerned, which is creating some dislocations in the T-bill market. T-bills maturing before June are trading at a 3.50% yield, over 150bps below the Fed’s policy rate. Meanwhile, T-bills maturing later in the summer are trading close to 5%. Assuming an agreement is reached on the debt ceiling, we still believe defensive positioning is warranted, since the Treasury will have to fill its general account with the Fed, which will on balance be a liquidity drain from the economy and markets.
Another eleventh-hour compromise is our base case scenario, which should weigh on risk assets and drive up market volatility going into summer. Ultimately, we expect the debt ceiling to be raised again, as it has been for over 100 years, and the can will be kicked down the road until next time.
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