INSIGHTS

On May 22, 2023

Debt Ceiling Standoff

Congress is on a fast-approaching collision course with the debt ceiling and Treasury coffers could run dry if the limit is not raised or suspended in time. Uncertainty will likely rise but market volatility may also create investment opportunities.

Our base case is a 90% probability of a last-minute agreement to raise the debt ceiling. However, the probability of a U.S. default is arguably higher than in recent years and should be carefully considered.

A quick reminder about the debt ceiling: The U.S. Constitution has always granted Congress authority over federal debt issuance. In 1917, due to wartime costs and upon passage of the Second Liberty Bond Act, Congress implemented a ceiling to avoid approving every debt issue. Since that time, Congress has had to continually raise the ceiling to fund agreed spending obligations, including repaying debt.

Today's impasse is similar to 2011

In 2011, the Republican Party (having won back the House of Representatives in the midterms) refused to agree to raise the debt ceiling without future spending concessions from President Obama’s administration. Talks repeatedly broke down until the 11^th hour. Amid the market volatility and uncertainty, S&P downgraded the U.S. credit rating from AAA to AA+, which has been unchanged since.

There are obvious parallels to today, however, the difference this time is the contentious position of House Speaker Kevin McCarthy, who was forced to grant significant concessions among factions of the Republican party, such as restoring the ability for any single House member to raise a “motion to vacate the chair” making a compromise bill complex.

A House bill that includes spending cuts will require support of the Democratic Party. Ratification in the Senate will necessitate enough Democrats agreeing to the cuts and voting with Republicans. This increases the potential for further gridlock. Finally, President Joe Biden has the option to veto any bill and has, at multiple times, stated that he is willing to do so.

Congress potentially only has until early June

The U.S. reached the debt ceiling on January 19, 2023, according to Treasury Secretary Janet Yellen. The Treasury’s next step has been to implement so-called “extraordinary measures” that involve suspending “special” forms of debt that also count against the debt limit.

On May 1, after reviewing federal tax receipts, Secretary Yellen revealed the Treasury’s estimated X-date to be “early June and potentially as early as June 1.” This is likely a conservative date with a large window but is more urgent than original market estimates.

Insight's expected scenarios:

1) Base case (90% probability): Resolution

We see a “clean” debt ceiling lift (i.e. with no concessions) as unlikely, instead a fiscal spending deal that pairs a debt ceiling lift with immediate or future spending cuts is our most likely outcome.

2) "Messy" case (8% probability): No debt ceiling raise but no default

If there is no agreement ahead of the X date, the White House may look to unconventional and unprecedented measures, such as payment prioritization or invocation of the 14th Amendment to prevent a sovereign default.

3) Disaster case (2% probability): U.S. sovereign default

The U.S. defaults on its obligations and sends the U.S. and global economies into a tailspin.

POTENTIAL CONSEQUENCES:

Base case (90% probability): Resolution

Ultimately, the prospect of a U.S. default is severe and is not in the interests of either political party. We believe that a compromise of some spending cuts attached to raising the debt ceiling is the mostly likely outcome.

At the same time, an early agreement will be hard to strike. As we approach the X-date, Congress will face mounting pressure to get a deal over the line, even one that merely kicks the can down the road. Business leaders, ratings agencies, regulators and markets could apply mounting pressure to politicians as the deadline approaches.

What could go wrong: If the government is forced to enact steep spending cuts, it could lead to reduced economic growth and job losses.

"Messy" case (8% probability): No debt ceiling raise but no default

If Congress fails to raise the debt ceiling, the White House will likely pursue one or more of the following options. However, if we can contemplate these options, so can Congress, which may make a deal less likely than in 2011.

1) Payment prioritization: The Treasury pays obligations to bondholders first, deferring payment to other creditors. It has some experience doing this through government shutdowns where it meets “essential” payments only. However, payment prioritization reportedly faces technological hurdles, so this could be a challenge, but one we would expect the Treasury to overcome in a pinch.

Our take: The best of a bad menu of choices. This likely keeps Treasury investors comfortable that the timeliness of principal and interest is secure, although technical default may trigger credit default swaps (CDS) and other contractual obligations.

2) Fed intervenes to keep market functioning: The Fed can potentially purchase and resell Treasury securities at risk of imminent default through the standing repo facility, which was initially created to ensure dollar liquidity for the banking system.

Our take: Holders of delayed securities can earn the repo rate on these securities, but the idea is at least complicated by member banks only being eligible and current size limit.

3) Treasury mints $1 trillion (yes, that says trillion with a T) coin: The Treasury is solely responsible for creating physical notes and coins, through the mint. Some have suggested creating a $1 trillion coin to deposit in its account at the Fed, thereby creating spending power without new debt.

Our take: Treasury Secretary Yellen and Fed officials have been strongly outspoken against this idea, questioning its legality. We believe this could lead to a significant inflationary and term-premium impulse as it could be considered an extreme form of MMT (modern monetary theory), or unfettered printing money or debt monetization.

4) Invoke the 14th Amendment of the U.S. Constitution: Section four of the 14th Amendment states, “The validity of the public debt of the United States…shall not be questioned.” Some argue this makes a U.S. default unconstitutional, allowing the debt ceiling to be ignored, potentially through a Presidential executive order.

Our take: Many legal scholars disagree with this interpretation of the 14th Amendment. We believe it is highly uncertain how the Treasury would proceed.

What could go wrong: Payment prioritization, even if achievable, is only a temporary measure. It also implies severe fiscal retrenchment as the Fed will need to neglect non-debt spending until a deal is made.

Minting a coin or invoking the 14th Amendment would almost certainly face legal challenges, likely leading to a U.S. sovereign credit rating downgrade, prolonged global market volatility and undermining global financial stability. The involvement of the courts may even lead to a default by reversing or delaying decisions. It will also likely trigger a constitutional crisis which, among other things, will undermine national institutions and the principle of separation of powers between the executive and legislative branches.

A messy debt ceiling process could also severely damage the US government's credibility and reputation as a stable partner in international affairs and damage the US dollar’s status as the world's reserve currency.

Disaster case (2% probability): U.S. sovereign default

At a minimum, a default would likely:

• Result in a run on money market funds, stablecoins (cryptocurrencies whose value is pegged, or tied, to that of another currency, commodity, or financial instrument), and even banking deposits as investors rush for cash.
• Jeopardize contractual agreements and investment guidelines where the full faith and credit of the U.S. government is used as collateral or stipulated.
• Result in all credit rating agencies downgrading the U.S. from investment to speculative grade (BB or lower) which would:
  • Dramatically increase the cost of funding for future U.S. debt obligations.
  • Leading to widespread forced selling.
• Cause the U.S. dollar value to plummet and lose its “exorbitant privilege.”
  • Potentially leading to the U.S. dollar losing its reserve currency status.
  • Resulting in American companies being asked to settle international transactions in other currencies.
• Cause inter-bank lending to come to a sudden halt as the cascading effects of the default reverberate across the global banking system.
• Drive up the borrowing costs for other borrowers in the economy, including households, businesses, and state and local governments.
• Raise a plethora of questions with no obvious answers, such as: “Would U.S. Treasuries still be accepted as collateral?” and “How will the system deal with delayed coupons or principal repayments?”

What could go wrong: The short answer…everything.

The U.S. and the world will likely experience a severe recession not dissimilar to 2008 and a near-complete credit market freeze. U.S. Treasury debt is the global benchmark safe haven, and its interest rates are the foundation for pricing a vast range of financial products. A default would undermine the foundation of the modern global financial system.

Fiscal policy may tighten if our base case is correct

We believe that markets will also be affected in the medium-to-long-term by the outcome of the legislation if our base case comes to fruition. We expect Republicans to succeed in achieving some spending cuts, which will temper the fiscal impulse to economic growth, and may come at a time when the economy is more sensitive to those spending cuts, given a higher Federal Funds rate environment. Sequestration from the 2011 debt ceiling compromise required $1.2 trillion in spending cuts over 10 years. The Congressional Budget Office estimated it reduced economic growth by 0.5% during its initial years.

It is a reminder that, as inflation continues to run high, authorities could push for tighter policy, not just from a monetary perspective, but from a fiscal perspective too. We therefore believe investors should remain vigilant and seek compelling fundamental value, as the overall investment backdrop will likely be highly uncertain.

Prepare for uncertainty and volatility.

Our list is not exhaustive and is highly uncertain, but the longer-term implications from this thought process implies an investment environment with structurally higher inflation and term premiums (the compensation that investors require for bearing the risk that interest rates may change over the life of the bond).

Ultimately, and as the X-date approaches, we believe investment diversification remains a worthwhile strategy when seeking to manage the near-term volatility and highly uncertain outcomes from alternative scenarios.

CRN: 2023-0508-10868 R

The opinions and views of this commentary are that of Insight Investment and are not necessarily that of Advisors Asset Management.

Any forecasts or opinions expressed herein are Insight Investment's own as of April 20, 2023 and are subject to change without notice. This information may contain, include or is based upon forward-looking statements. Past performance is not indicative of future results.

AAM was not involved with the preparation of the articles linked to in this commentary and the opinions expressed in these articles are not necessarily those of AAM.