This week we wanted to discuss the debt ceiling, a topic that has been getting a lot of attention lately. We have written on this topic before, but felt it was worth revisiting.
The debt ceiling/limit is the total amount of money that the US government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, interest on the national debt, tax refunds, etc. It does not authorize new spending, but simply allows the government to finance its existing legal obligations. Given the government spends more each year than it brings in from tax revenue, it must continually borrow to cover the difference – causing national debt to rise over time. Congress continually sets a limit on this debt, currently $31.4 Trillion, which was reached on January 19th of this year. The Treasury has been using tax revenue and so-called “extraordinary measures”, or accounting tools, to keep debt below the limit. Some potential examples of these measures are prematurely redeeming Treasury bonds held in federal employee retirement savings accounts (and replacing them later with interest), halting contributions to certain government pension funds, suspending state and local government series securities, borrowing from monies set aside to manage exchange rate fluctuations, etc.
Treasury Secretary Janet Yellen sent a letter to Congress outlining that the Treasury will exhaust its resources under the debt limit “potentially as early as June 1” setting up a possible breach/default. It is important to immediately address that this default would almost certainly be a technical default, where payment deadlines are missed by a day or two rather than an actual default in which payments are not made at all. Also, while there are debates around the true “X-date” (given the timing uncertainty of tax revenues), we would rather focus on the ramifications of the event itself.
There have been 89 debt ceiling increases since 1959, under a variety of administrations. During the recent close call in 2011, stock prices fell almost 20% as Congress narrowly avoided a default and as a result the US was downgraded from AAA to AA+. The rating agency, Standard & Poor’s, cited political dysfunction as a driving risk for the downgrade. I think most would agree political dysfunction has increased, not decreased, since that time.
If Congress doesn’t raise the debt ceiling by the X-date, the Treasury would start having to miss payments. The Treasury doesn’t like to disclose a plan for maintaining some level of stability in that situation, as sharing a plan might encourage lawmakers to discount the severity of such an outcome. That being said, we can look at the reports surrounding the 2011 debt limit battle for clues. During that close call, the treasury was prepared to prioritize paying principal and interest on Treasury securities from available tax revenues. Timing of other payments (Medicare, Social Security, etc.) would depend on the timing of tax revenue. Prioritizing treasury repayment is important, as failure to do so, would result in financial market instability and may permanently impair the US Government’s financial standing. We would estimate that in this scenario, investors would demand several basis points more in interest going forward on trillions of Treasury debt to compensate for the risk that a debt ceiling issue would happen again. This would add up to a significant cost to taxpayers.
Many suggestions have been made regarding alternative methods that the Treasury Department or White House could employ to buy more time. These unprecedented actions include selling substantial quantities of gold, minting a unique high-value coin, issuing IOUs that could be sold and traded in private markets, or invoking the Fourteenth Amendment to bypass the statutory debt limit. It remains uncertain whether any of these options are genuinely feasible or what the economic and political ramifications would be if such measures were taken. The only clear option to avoid a default would be for Congress to raise or suspend the debt ceiling.
Daleep Singh, a former economic aide to Biden and now chief global economist for PGIM Fixed Income, a near trillion-dollar investment firm, is more worried now than he was in 2011. He sees a 5% probability of a debt default and a 50% probability of a “breach” (that the government won’t default on its debt but will miss some other spending commitment). Moody’s, another rating agency, assigns a 10% probability of a breach.
Are markets pricing in this risk? The short end of the treasury curve is, with T-Bills around the X-date yielding more than their earlier or later counterparts. Also, the price of credit default swaps (CDS) on Treasuries has moved much higher. CDS is insurance against the event of default and is currently priced at 150 basis points, meaning it now costs $15 to insure $1,000 worth of treasuries against default. This can be a thinly traded market, so it needs to be taken with a grain of salt, but it’s still interesting to see that CDS is now more expensive than it was even in the Great Financial Crisis.
Our base case is that the debt ceiling issue will go down to the wire. We still assume it will be resolved before a breach, but it may require some panic from financial markets to motivate lawmakers. Even if the debt ceiling was breached, it is inconceivable to us that it would be prolonged as financial markets would be reeling and late payments to Medicare/Social Security constituents should quickly motivate lawmakers to reach a deal.
While all has been mostly calm in the stock market so far, we anticipate volatility to pick up as we near or pass the X-date, and we may look to take advantage of any favorable prices that emerge.
