Markets have grown accustomed to the US debt ceiling drama, but 2023 has the potential to be even more dramatic. Political analysts may enjoy the war gaming but, for investors, there are only two distinct scenarios – neither particularly encouraging.
The first scenario is the base case currently dominating markets, namely a compromise deal ahead of the X date (when the Treasury hits the technical limit and cannot continue business as usual). However, this assumes that the natural dynamics of the political process will lead to a negotiated deal. In reality, it will require an exogenous force to break the current political impasse. This could be a foreign policy emergency but it 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).
Figure 1. Markets beginning to reflect default risks earlier
US credit default swap spread, basis points
Source: Macrobond, as of 15 May 2023
However, for market stress to become a substantial ‘political force’, it must worsen. For the needle to move, it would not only require big moves in short-term US Treasury yields but also a sizeable 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. In 2023, these types of market moves would have to precede any last-minute political compromises.
What would not be temporary – and what may have helped the equity drawdown in 2011 – is the fiscal contours of any bipartisan deal. Directionally, we know that significant spending reductions would be embedded in any 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 passed by the House of Representatives in April has pencilled in $4.3tn in spending cuts over 10 years. Any compromise would be less than half that figure, but would still be equal to 1% of nominal gross domestic product being shaved off per year in 2024-26. In real terms, the hit would be somewhat less but still substantial, and the tightest fiscal stance since pre-2008. 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.
One victim of any fiscal deal would be the end of the Federal Reserve’s quantitative tightening. The economy would not be able to handle both fiscal and monetary policy draining liquidity from the system simultaneously. The last rate hike will have been in May 2023, so the Fed is likely to object to financial conditions tightening. And with the explosive burst of new Treasury issuance following a debt ceiling deal, QT will no longer be sustainable. At the same time, inflation, as well as growth, is bound to be lower in that environment – although inflation volatility could remain elevated as the world becomes more vulnerable to supply shocks.
The alternative scenario 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 X-date deadline would pass. In this scenario, we would expect President Joe Biden’s administration to draw on controversial legal justifications to continue to make debt payments (despite denials of technical and political feasibility), thereby delaying non-debt obligations as much as possible to avert any technical default.
Given the unprecedented nature of such actions, market reactions would continue to exude extraordinary volatility with very rapid moves in short-term rates and sharp drawdowns in equities, commodities and other risk assets (Figure 2). Against this background, rating agencies are likely to issue a credit watch or a downgrade even without an actual missed bond payment, which could set off a chain of negative reactions across bond markets.
Figure 2. Market reactions will continue to be volatile
Chicago Board Options Exchange volatility index, 2011 versus 2023, adjusted closing price
Source: Macrobond, as of 15 May
To calm financial stress, the Fed could help by offering to swap some of their System Open Market Account holdings (currently $367bn of Treasury bills) for any Treasury issue maturing at the time.
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 worst case scenario, 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, it may also result in the more pessimistic economic forecasts actualising.
Elliot Hentov is Head of Macro Policy Research at State Street Global Advisors.
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