Markets have grown accustomed to the debt ceiling drama, but 2023 has the potential to be an even more dramatic year. Given this possibility, we review the key debt ceiling scenarios, their impact on the macro-outlook and investment implications thereof.
In our view, there are three distinct scenarios through which the debt ceiling episode could playout for the financial markets:
1) a non-event,
2) a temporary stress period with lasting fiscal impact and
3) a severe risk-off event with knock-on consequences.
For the debt ceiling to be a non-event, it requires a timely political compromise between the Democrats and the Republicans before the appearance of any undue market stress. Given the competing interests of both sides, we find this to be highly unlikely. Republicans view the debt ceiling as a bargaining leverage ahead of the 2024 US presidential election, while Democrats consider any concession as an abuse of constitutional arrangements. Also, Democrats now view Barack Obama’s negotiations in 2011 and 2013 as a political mistake not to be repeated.
The most plausible avoidance of a crisis would be a short-term delay in aligning the debt ceiling deadline with the end of the budgetary cycle in late September. This would hold electoral appeal for Republicans to fold the debt ceiling into a broader fiscal policy debate. Democrats would certainly prefer to avoid this outcome but may accept it as a lesser evil, perhaps with the hope that the timing of US Treasury’s extraordinary measures could permit a few weeks of government shutdown prior to the so-called “x-date” (when the debt ceiling will limit new debt issuance and Treasury can no longer meet all its obligations). In this scenario, markets would simply be facing the same outlook a few months later.
The reality is that an exogenous force is required to break the current political impasse. This could be a foreign policy emergency but is more likely to be financial market stress. During the first major standoff in 2011, markets started to price in default risks only a few trading days ahead of the deadline. Since then, markets are reflecting this risk earlier and more significantly (Figure 1).
However, for market stress to become a substantial "political force," it must worsen. This means, for the needle to move, it would not only require big moves in short-term US Treasury yields but also a sizable drawdown in the equity market. In 2011, the S&P 500 lost only about 5% in advance of the political deal but dropped another 10% in the days that followed (Figure 2). In 2023, these types of market moves would have to precede any last-minute political compromises, including a bipartisan deal.1
What would not be temporary, and have arguably helped the equity drawdown in 2011, is the fiscal contours of any bipartisan deal. What is included in that deal matters enormously. Directionally, we know that significant spending reductions would be embedded in medium-term fiscal plans. In other words, after several years of massive positive fiscal impulses, the economy will suddenly have to contend with a material fiscal drag.
The Republican bill has penciled in US$4.3 trillion in spending cuts over ten years. Any compromise would be no more than half that figure, but that would still be the equivalent of 1% of nominal GDP getting shaved off per year in 2024-2026. In real terms, the hit would be somewhat less but still substantial and the tightest fiscal stance since pre-2008 (Figure 3). This is why aspects of the bill that attempt to resolve the debt ceiling crisis (i.e., the agreed-upon budgetary savings) hold such importance.
The deal’s more austere fiscal positioning is likely to occur alongside a less-accommodative monetary stance. After all, even as we expect the US Fed to be in a position to cut rates before end-2023, there still remains a need to reduce the Fed’s balance sheet. In this scenario, both fiscal and monetary policies are likely to be set up for draining liquidity from the system – the reason we think the Fed’s quantitative tightening (QT) will have to end after the debt ceiling. The last rate hike will have been in May 2023, so the Fed is likely to object to financial conditions tightening. And with the likely explosive burst of new Treasury issuance following a debt ceiling deal, QT will no longer be sustainable.
At the same time, not only growth, but inflation, too, is bound to be lower in that environment, although inflation volatility could remain elevated as the world will be more vulnerable to supply shocks.
The alternative to any resolution of the debt ceiling would be a non-resolution, leading to more extreme market reactions as chances of a default in US debt would continue to rise. This does not imply a debt default but simply that the deadline would pass. In this scenario, we would expect the Biden administration to draw on controversial legal justifications to continue to make debt payments (despite current denials of the technical and political feasibility), thereby delaying non-debt obligations as much as possible to avert any technical default (see Addendum).
Given the unprecedented nature of such actions and the fiscal impact of suddenly freezing large channels of regular government expenditure, market reactions could continue to exude extraordinary volatility with very rapid moves in short-term rates and sharp drawdowns in equities, commodities and other risk assets (Figure 4). Against this background, rating agencies are likely to issue a credit watch or a downgrade even absent an actual missed bond payment, which could set off a chain of negative reactions.
In the aftermath of the SVB crisis, we were reminded how quickly risks can snowball out of control. Soon after the bruising experience of a widespread deposit flight, the last thing any US banking institution needs is a sudden decline in loan collateral values and a surge in non-settlements. Similarly, the last thing that the US itself needs is another debt downgrade that could impact the ability of certain buyers to own US debt.
While this would be unprecedented, the Fed could help sustain this situation by offering to swap some of their System Open Market Account Holdings (SOMA) holdings for any particular Treasury issue maturing at the time. Currently, the Fed owns US$367 billion of Treasury bills (T-Bills), and while balance sheet expansion and politicization are clearly counter to their current policy stance, these could come under consideration during a scenario of extreme financial stress.
Lastly, once precedent is broken, it is not clear how a sustainable balance is restored. Any political truce could re-erupt with the budget discussion in late September and any unilateral action of the Biden administration could trigger a judicial review process. Either way, some residual higher uncertainty would be sustained, which will anchor tighter financial conditions and prolong a risk-off environment.
The debt ceiling dispute in 2023 is unlikely to be a passing phenomenon. At a minimum, it will produce lasting fiscal headwinds to the US economy and in a worse-case scenario, it could constitute a durable financial stress event. In both cases, long-term yields are likely to come down and risk assets will underperform. As a result, to a certain degree, it may result in the more pessimistic economic forecasts actualizing.
How the UST Market Functions and What a Technical Default Would Look Like
Most people own US Treasury debt in some form or another. The largest holders are the Federal Reserve and various government accounts, followed by foreign governments, mutual funds, banks, state and local governments, pension funds and insurance companies (Source: The Balance, 19 January 2023). Additionally, individuals and other entities may hold US Treasury debt directly. Currently there is US$31.4 trillion of Treasury debt outstanding of which US$24.3 trillion is publicly traded in the form of T-Bills, notes, bonds, TIPS and floating rate notes (Source: US Treasury, Bloomberg, as of 31 March 2023).
Treasury debt matures or is paid back in full by the US Treasury on a regular schedule determined by bond tenure. Each week T-Bills mature on Tuesdays (1, 2 and 4-month maturities) and Thursdays (3 and 6-month and 1-year maturities). Longer-term US Treasury notes, bonds, TIPS and floating rate notes mature on the 15th or the last day of the month depending on the issue. During a given week there could be approximately US$150 to US$300 billion of T-Bills maturing, and on a monthly basis there could be over US$300 billion of notes, bonds, TIPS and floating rate notes maturing.
If there is any missed bond payment, we see at least three possible scenarios: 1) Closed loop in the financial markets; 2) Open loop in the financial markets; and 3) Open loop in the real economy. Typically, when debt matures, the proceeds from that maturity have already been reinvested or spent on something else.
In the first scenario, closed loop, a Treasury debt owner would have reinvested their maturity into new Treasury debt issues at auction. In this instance, there would be no knock-on effect because the proceeds of the Treasury maturity would be used to buy Treasury debt, thereby ultimately returning the cash to the US Treasury; if the Treasury did not pay the holder upon maturity, then the Treasury would not receive the reinvestment. Both sides of this “failed” trade are within the US Treasury and thus, contained.
In the second scenario, open loop, the Treasury issue is held at a custody bank and the proceeds are used to purchase another financial asset. Since there are no maturing proceeds to pay for the purchase, the new purchase would “fail” to settle. This could create a domino effect should multiple trades rely on Treasury maturity payouts. The resulting fails could have an exponential effect and potentially create a systemic trade failure in the hundreds of trillions of dollars across any number of different asset classes. Additionally, a significant number of derivative trades have T-Bills posted as collateral. If a T-Bill fails to pay at maturity, it will result in a collateral shortfall, raising the potential for margin calls and a scramble for liquidity.
The Depository Trust Clearing Corporation is responsible for the vast majority of security settlements in the US and reports daily US Treasury failed trades. Over the past year, on average, there have been US$40 billion of US Treasury failed trades per day. These failed trades are typically resolved in a day or two. There are a significant number of “short” positions in the Treasury market (the Treasury is sold and then borrowed to allow for settlement) where the borrow is delayed and thus the trade fails. There is a failure charge assessed to the entity that does not deliver.
If a Treasury’s maturity were delayed, it would not be considered a failed trade. If the maturing proceeds were to be used to buy other US Treasuries and those trades could not settle, the trades would be considered a failure and a fee equal to the Fed’s reverse repurchase agreement rate +100 bp would be applied (4.80% + 1.00% = 5.80% at the time of this writing). These failure charges could add up to millions of dollars for a single day.
In the last scenario, open loop in the real economy, the maturing Treasury proceeds are used for any number of reasons in everyday life. This could include retirement benefits, business operations, government operations, M&A activity and ordinary household payments to name a few. A delay in payment in this situation would have considerable cost and impose a strain on the commercial and retail banking system. Overdrafts could occur and banks would need to extend credit to enable the flow of credit in the real economy.
There is little doubt that the US Treasury will make good on the payment of any maturing debt once the Congress allows for a higher borrowing limit. Therefore, the risk to owning Treasury debt that may be delayed in paying is the potential loss of interest during that period. It is possible that the Treasury announces plans to compensate owners for that loss of interest. Many market participants will try to sell the debt to avoid the problem. But for those that cannot, it will be critical that the maturing proceeds are not needed for any other activity in the capital markets or the real economy.
1 An alternative scenario would be where other forms of bipartisanship prevail under market pressure, such as a discharge petition initiated by Democrats that only requires the support of five Republican rank-and-file congresspeople. All in all, this scenario would witness a meaningful, albeit temporary, tightening in financial conditions, as any bipartisan resolution would shift the next debt ceiling limit to 2025 or later. However, the odds of this are extremely low as the discharge petition would require 37 legislative days of preparation and Republican unity in the House disqualifies that pathway.
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