The US debt ceiling: the final countdown
Summary
· On 19 January 2023, the US government debt reached the statutory debt limit. As the Treasury can no longer borrow money, it can only rely on its cash balance and some accounting manoeuvres to stay below the debt ceiling and avoid default, which could happen as early as 1 June according to Treasury Secretary Yellen.
· Congress can either increase or suspend the debt ceiling to avoid a default, but Democrats and Republicans are divided so far.
· The political stand-off is generating market stress: the US Credit Default Swap has increased substantially, and the Treasury-bill curve is showing dislocations in early June maturities. Short-term T-bills are attractive in our view as we do not believe that the Treasury will miss a payment.
· Other asset classes do not show particular signs of stress e.g. equities are not collapsing and gold is not going through the roof.
· When Congress reaches a resolution, money market rates should move higher.
· If Congress does not reach a deal before the Treasury runs out of cash, then the US would default on its debt, causing a major worldwide turmoil on financial markets, and the Fed will not be able to mitigate the consequences.
What is the debt ceiling?
The debt ceiling was established in 1917. It was intended to allow the US Treasury to raise debt without prior authorisation from Congress as long as the total debt remained below a certain ceiling. Since then, the ceiling has been raised 95 times through political negotiations, often at the very last minute.
If Congress fails to raise or suspend the debt ceiling, then the US government would default on its debt obligations, which would inevitably create a worldwide financial chaos. This remains extremely unlikely given the consequences of such an event. No party would want to be responsible for this. The US has no medium-term problem of debt sustainability.
Has the US reached its debt ceiling?
Yes. On 19 January, government debt reached the statutory debt limit of the USD 31.4trn. Hence, since that date, the Treasury has relied on its cash balance (the Treasury General account – TGA) and on some accounting manoeuvres (known as “extraordinary measures”) to stay below the debt ceiling and avoid default. Extraordinary measures mean that for instance the Treasury has suspended new investments and has redeemed certain existing investments in both the Civil Service Retirement and Disability Fund and the Postal Service Retiree Health Benefits Fund.
What is the X-date?
The X-date is the day the Treasury’s cash balance and extraordinary measures run out and the US government defaults on its debt obligations. Treasury Secretary Yellen thinks it could be on 1 June. However, it’s impossible to know for sure when the X-date will be as it depends on the Treasury’s cash balance which, in turn, depends on daily fluctuations in tax revenue, spending and borrowing. Higher-than-expected economic growth and increased tax receipts could postpone a default while lower tax receipts (or more tax refunds) could result in a sooner-than-expected default.
What can Congress do to avoid the US defaulting on its debt?
Congress can either increase or suspend the debt ceiling to avoid a default. For Democrats, as President Biden said, “raising the debt ceiling is not a negotiation, it is an obligation of this country.” For Republicans, any increase in the debt ceiling must be paired with deep spending cuts, including on President Biden’s clean energy programme, such as the elimination of Biden’s student loan forgiveness plan and the repeal of most of the new renewable energy tax incentives codified in the Inflation Reduction Act. Democrats and Republicans need to find a compromise. Neither want to be blamed for a potential sovereign default or government shutdown when the US Presidential and Congressional elections are not far away (November 2024).
Are there any solutions to delay the X-date?
There are a few loopholes that can be used to delay the X-date, but they are not without consequence.
The most discussed one is that the President could evoke the 14th amendment that stipulates that the validity of the public debt of the US shall not be questioned. Some argue that the threat of a default would call into question the validity of the US public debt, hence that President Biden could bypass Congress and allow new debt issuance. Such a decision would inevitably cause a constitutional crisis, involving the Supreme Court involved and creating financial instability.
Another loophole to exploit is that Treasury could mint a platinum coin of USD 1 trillion, deposits it on its cash balance at the Fed (should the Fed accept it), and then use those funds to carry on financing its activities.
Another solution to bypass the debt ceiling is that Treasury could issue, say a USD 1,000 bond with a much higher coupon than what it should be under current market pricing. Hence, that bond could be issued for more than USD 1,000. The Treasury could argue that this bond actually replaces a maturing USD 1,000 bond. As such, the Treasury would have raised more money without increasing the debt.
Those solutions for delaying the X-date are not optimal at all as they can be legally challenged. The best way is for the Biden administration to prioritise spending so as to temporarily postpone some spending, and thereby delay the X-date a little.
What is the impact on financial markets so far?
The notable moves so far are the sharp rise in Credit Default Swaps (CDS – an insurance against default), the dislocation in the Treasury bill market (T-bills are US government debt with a maturity between 4 and 52 weeks), and to some extent, the weaker dollar. Other asset classes do not show particular signs of stress, e.g. equities are not collapsing and gold is not going through the roof.
Why the CDS is so high?
Credit Default Swaps (CDS) are financial instruments that hedge against default. They can also be a tool for speculation. The 1-year CDS on the US jumped to a new all-time high, at 166 basis points on 16 May, meaning that it costs EUR 16,600 to ensure a USD 1 million government bond against a risk of default, while it cost only EUR 8,000 in 2011 during the previous major debt ceiling standoff.
However, it does not mean that the market-based probability of default is higher in 2023 vs. 2011. Indeed, the probability of default depends not only on the level of the CDS but also on the price of the cheapest-to-deliver bond. As the Fed has increased rates at a very rapid pace since 2022, bond prices have collapsed. The price of the cheapest-to-deliver bond is much lower now (Treasury 1.25% 15/05/2050 at 56.4% on 15 May) than it was in 2011 (87.7%). Hence, even if the current CDS level is strikingly high, it implies a probability of default of only 3.8%, while it was 6.5% in 2011.
What’s happening to T-bills?
The T-bill curve is showing dislocations in early June maturities, indicating when investors are most worried of a potential default. Risk-adverse investors and money market fund managers have been piling into T-bills that mature before the X-date (1 June as per Treasury Secretary Yellen), causing their yield to drop below 3.5%.
On the other hand, T-bills that mature on around the X-date have seen their yields surge. The T-bill maturing on 6 June offers a yield of 5.3%. By comparison, a T-bill that matures one month later yields less (5.0%). We find T-bills attractive as we do not believe that the US will miss a payment or default.
What impact on corporate bonds?
The impact on credit has been mild so far since bond participants view the probability of a credit event unlikely. There were also no particular signs of stress in previous debt ceiling standoffs, except in August 2011, when credit spreads widened significantly, but that was more due to the fact that S&P had downgraded the sovereign rating of the US rather than to do with the debt ceiling stand-off itself.
Note that S&P lowered the US’s credit rating from AAA to AA+ in August 2011 because of resilience to new revenue measures and scepticism about the serious consequences of a default expressed by numerous US politicians during debt ceiling negotiations. We assume that US politicians have learnt their lesson this time and that rating agencies will therefore not downgrade the rating of the US and credit spreads will widen only moderately, not because of the debt ceiling drama but because monetary policy is tight.
What impact on the economy?
A prolonged stand-off could result in a partial/temporary government shutdown and lower economic growth, at a time when recession concerns are elevated. Non-essential administrations, such as federal parks and museums, would not be able to open and civil servants would not be paid (in the past, they received their salaries after the budget was passed). The US Congressional Budget Office estimated that the five-week partial shutdown at the end of 2018 had reduced GDP growth (not annualised) by about 0.06% per week.
What will happen when the debt ceiling is finally raised?
When Congress reaches a solution, the Treasury will need to replenish its cash balance. We thus expect a massive wave of issuance of T-bills of around USD 500 bn so that the Treasury cash balance can increase to USD 600 bn.
A higher Treasury cash balance results in a withdrawal of liquidity from private markets. That contraction in liquidity, combined with high net T-bill issuances in Q4, should lead to higher money market rates.
What will happen if Congress does not reach a deal after the X-date?
While we see this scenario as very unlikely, if the US misses a payment on its debt, it will result in a default. The US will benefit from a 3-day grace period to honour its payment obligations. If it fails to do so, it will be considered as a credit event and owners of CDS will have their bonds reimbursed at par, in EUR, not in USD. A default will have unimaginable consequences on global financial markets, most likely resulting in a collapse of the dollar, of equity markets, of bond markets...and so on. Gold may be the only winner in such a catastrophic scenario.
Can the Fed do something in the worst-case scenario?
No. Fed Chair Powell said that the Fed cannot protect the economy from the potential effects of a failure to pay bills on time. Officially, the Fed does not want to be involved in discussions on contingency plans.
The baseline assumption (according to the August 2011 FOMC transcript, when debt-ceiling negotiations were at an impasse) was that principal and interest on Treasury securities would continue to be made “on time”, and that other payments may be delayed. This is likely to be true in 2023 as well, if it comes to that. One can however wonder how the Treasury will manage to sort and prioritise payments since it processes about 80 million payments every day (estimated average in 2011).