US Debt Ceiling: Much Ado About Nothing?

The intensifying discussion surrounding the debt limit in the United States has gained increasing attention in the media during the last weeks, especially since Treasury Secretary Janet Yellen announced that a potential default of the US could occur as soon as June 1, 2023. In the US, the accumulated amount of debt which is accrued by the government to finance its reoccurring deficits is subject to an overall limit, at which no new debt can be taken up. Said limit of USD 31.4 trillion has been reached on January 19, 2023 (see left chart below). Since then, the US Treasury has been implementing so-called “extraordinary measures” (mostly accounting maneuvers) and relying on its cash account (see right chart below) to prevent the US from defaulting. However, these countermeasures could be exhausted as soon as early June. If the debt ceiling were not raised by then, the US Treasury would be unable to satisfy its existing obligations, including the redemption of US-government bonds, coupon payments related to them, wage-payments to state-employees, social security payments, etc.

For the debt ceiling to be increased however, both chambers of the Congress, the Senate and the House of Representatives, need to agree on a lifting of the limit. Nevertheless, while the Republican Party, whose members have a majority in the House, want to couple an increase of the debt ceiling to cuts in future spending, the Democrats, which make up the majority of the Senate (and supply the president), favor a clean increase. This disagreement so far has prevented any arrangement. Mutual consent would be desperately needed though.

The most likely scenario is that an agreement between the parties involved will be found eventually (as was the case at numerous occasions in the past). This could be either a clean increase, or an increase linked to spending cuts, as demanded by leading Republicans. A suspension of the debt ceiling is another possibility (this would only shift the problem to the near future though). If no agreement is found, the US would ultimately default on its debt. Here, a differentiation between a short-lived default and a prolonged default should be made, with the latter likely being even more severe than the former. Additional, but rather unlikely measures that could be undertaken if no agreement is found include, e.g., President Biden claiming that the debt ceiling violates section four of the 14^th amendment of the US Constitution, the minting of a trillion-dollar coin, or the issuance of premium bonds. On a further sidenote, it should be stressed that a government default must not be confused with a government shutdown. While the former has never occurred before and deals with the capability of the US to serve its existing debt, the latter has materialized at multiple instances throughout the past and deals with the capability of the government to pay some of its employees if government officials fail to agree on a budget for the next fiscal year. A default would hence be much more dramatic than any shutdown experienced before.

Certain financial market-segments currently are pricing in elevated risks for a default of the United States. Looking at the lower left chart, it becomes obvious that 1-year CDS spreads are at a record high, which hints at investors trying to protect themselves from a default or alternatively speculating on such an event. Furthermore, it can be observed that such short-term CDS spreads tend to be especially elevated in times of uncertainty surrounding the debt limit, the debt ceiling crises of 2011 and 2013 being prime examples for such episodes. Also yields on short-term US government bills are affected by the tedious negotiations. As the lower right chart shows, yields on 1-month bills saw a pronounced increase as of mid- to late April. Bills with a longer maturity of 3 months also experienced an increase, which was however much less pronounced. These described market reactions show that, even though issues surrounding the debt ceiling have always been resolved in the past, markets are still factoring in the possibility that no agreement will be found this time around.

Markets visibly reacting to even the slightest risk of a US-default underlines one argument: The possible consequences thereof would be dramatic. With US-Treasurys and the US-Dollar, the US provides two assets that are extremely important for global economies and financial markets due to their use in global trade and their safe-haven properties, respectively. These assets losing their credibility due to a default would hence drastically alter the global economy. Besides a deterioration of equity and credit markets as well as a weakening of the US-Dollar, a default would cause a rating downgrade of the US, which would lead to a persistent increase of federal borrowing costs. Additionally, trust in the banking sector could deteriorate further, which could trigger severe bank-runs (which have been observed at regional banks in the past months even without a default). Above all, a US default would cause immense uncertainty of how the global financial system can remain functional with the largest source of risk-free collateral being in default. Economically, a rise in unemployment as well as a drastic decline in economic growth should be expected. However, contrary to past downturns, the government would have no funds at its disposal to cushion the fall. Long-term, a rise in lending costs for both households and businesses would likely exert additional downward pressure onto the US-economy.

The debt ceiling debate has been reflected in the financial news for months and has now also been the subject to public discussion for a few weeks. Stock markets are forward-looking and if there is one thing they are least impressed by, it is widely discussed and well-known topics. The markets are watching the political battle closely and usually take their guidance from comparable events. History does not repeat itself, but it rhymes, Mark Twain is supposed to have said once. There is hardly an event to which this quote applies as well as in the case of the debt ceiling. The recurring debates often differ in the details, but the framework conditions have been the same for years. More precisely, the debt ceiling has been raised more than 100 times since its introduction in 1917.

As mentioned above, the debate around raising the debt ceiling in 2011 would be well comparable to the current political situation. And indeed, the broad US equity market, as measured by the S&P 500, came under pressure at the time. But the problem is that the 2011 debate also coincided with the European debt crisis, so sentiment was also affected by other factors. This is the general difficulty in examining what impact the debt limit discussion has had on the stock markets historically. As a rule, the debates drag on for several weeks and months, so that their influence on the stock markets cannot be clearly distinguished from other influencing variables. Nevertheless, to provide a point of reference, we look at the period of one month before and after the expiry of the deadline. We restrict ourselves to the recent past and adjust the events since the 1990s for the crisis periods with long-lasting distortions (dotcom, financial crisis).

The result is not surprising. If we take the Volatility Index VIX as a barometer of fear, we can see a clear increase in nervousness in the course of the discussions. On average, the implicit volatility rose by around 20% in the run-up, which was generally — if not completely — reduced again in the following month. The fact that investors should not be put off by this, however, is evident above all from the returns actually realised. On average, it is even moderately positive during the debates about raising the debt ceiling, but in the following month it is clearly above 1%. It is therefore advisable for investors not to underestimate the resilience of the stock markets. A heightened level of nervousness stems mainly from the headlines. However, history shows that politics has always done its job so far — no wonder, after all, political re-election is a good incentive for compromise.

We therefore stick to our stock market view and assume that the parties will come closer together. Even then, however, it is only a matter of time before the debate starts all over again in the foreseeable future — as has been the case for the last 100 years.

At the time of writing, negotiations between the main discussants are still in progress. Currently, it seems as if the involved parties are slowly and carefully moving towards each other, even though most recent discussions once again underlined disagreements between the participants involved. In our opinion, a clean increase of the debt ceiling, as demanded by Democrats such as President Biden, is unlikely. We also do not think that the Republicans (represented by speaker of House Kevin McCarthy) will eventually manage to push through all of their initial requirements, especially since many of them are aimed at retracting programs installed by President Biden himself. We do therefore see an increase coupled to some of the initial republican requests as most probable. Finding a consensus could be hampered by hardline Republicans which claim that they could block any agreement which they deem to be insufficient. However, government officials, independent of party affiliation, are well aware of the drastic consequences which even a short default could potentially have (also on themselves). They will therefore try to prevent an actual default, no matter what. Likewise, financial markets are, as of yet, only assigning a small probability to such a catastrophic event. Nevertheless, negotiations could be conducted until the latest moment possible, which may cause some more volatility on markets. After all, the debt ceiling in its current form is a perfect tool for political saber rattling, and it would be surprising if participants within the discussion would let this chance pass by unused.