January 23, 2023
Dynamics of the Debt Ceiling
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Below is a transcript of this week’s video:
Treasury Secretary Janet Yellen announced last Thursday that the U.S. has officially hit the debt ceiling, marking one of the freshest risks which investors must grapple with in 2023. This all has to do with how the Treasury gets the cash it needs to pay its bills which, in a bit of a simplified format, follows the following steps. First, If the federal budget runs a surplus, the Treasury can use those extra funds to replenish their cash reserves. Large deficits, on the other hand, can drain these reserves. Second, when running a deficit as it usually is, the Treasury borrows more through the capital markets by issuing new bonds, but with the catch that there’s usually a limit to how much they can borrow unless that limit is raised or suspended. Third, once that limit has been hit, as it was last week, there are two paths that can be taken: either Congress acts on the debt ceiling or the Treasury is forced to enter what’s called a “Debt Issuance Suspension Period,” which is just a fancy way of saying it will shift some money around and postpone new investment to tide itself over for a little while longer. Last, If the debt ceiling isn’t addressed before the Treasury runs out of money, it risks a default scenario. This would involve, among other things, missed payments on Social Security, Medicare, military salaries and/or interest and principal payments on debt, which would be a very disruptive event.
Let’s get the obvious out of the way first, in that a budget surplus is unlikely to come to the rescue as a cash source. In fact, the federal government is running one of the largest peacetime deficits in its history. All else equal, this acts as a net drain on cash and perhaps hastens the need for Congress to act.
They need to act because the Treasury just hit the ceiling of a little more than $31 trillion in debt, so it can no longer use its ability to borrow to raise funds. Congress essentially has two options: They can raise the debt ceiling to a new level that allows additional borrowing, or they can opt to suspend the debt ceiling until a fixed future date, which is why if you look at historical debt levels versus the limit that there are periods where debt is allowed to run higher for some time.
Enter that phase of extraordinary measures, when the Treasury taps various sources for cash on a short-term basis to hold itself over. Historically, that has bought the government a few months until cash levels have gotten dangerously low. Predicting exactly when that will happen is difficult, since not all of the government’s obligations are fixed and knowable in advance. For example, when tax season rolls around, if taxpayer refunds are higher than normal, this could accelerate the process and vice versa. With that said, a reasonable estimate as to how long Congress has to act on this is sometime around this summer.
What if Congress doesn’t act to raise the ceiling by then? It is a bit of a doomsday scenario, but a default event would likely prove to be quite disruptive. For one, U.S. government bonds are treated as the world’s de-facto risk-free securities, relative to which many other assets are priced. If investor confidence becomes sufficiently shaken, reduced demand could lead to higher borrowing costs. In particular, foreign investors represent one in every four owners of U.S. debt, and if they start to think the promises behind those bonds are less than solid, they may seek what they perceive to be safer investments elsewhere. That declining demand could lead to higher rates, not just for the government but for corporations and individuals, too, since Treasury yields often act as the basis from which many other bonds price. In addition, this could lead to contagion in financial markets since Treasuries are often used as collateral for borrowing. For example, roughly 75% of short-term borrowing in the repurchase agreement market is backed by Treasury holdings. A repricing in those bonds could lead to margin calls and/or forced deleveraging, which could cascade through the financial system.
If that sounds dire, there’s no way to sugarcoat it — a default would be a pretty big deal. While we believe a default is not the base case outcome, political polarization and recent contentiousness within the U.S. House of Representatives likely increases the likelihood on the margin. A good way to gauge how investors are handicapping that risk is to look to the credit default swaps market. These swaps are essentially a form of insurance against default. Short-term pricing in credit default swaps for U.S. sovereign debt is currently high relative to its history. They’ve risen to levels similar to their 2011 highs, when the debt ceiling last emerged as a contentious issue but was eventually resolved without a default event. This is something investors should be watching closely to gauge the seriousness of the situation over time. As it stands now, the debates in Congress on the issue are likely to begin heating up, but the true deadline for action is likely not until later this summer.
To summarize: The debt ceiling has been hit, halting new bond issuance. The federal budget is operating at a sizable deficit, which is one of the factors hastening the need to raise the ceiling. Until Congress does so, Treasury will be able to employ extraordinary measures to avoid default, which should last until summer. If a default were to occur, it would likely lead to higher rates and financial market disruptions. Pricing on insurance against U.S. default has hit levels similar to 2011, the last time the debt ceiling became a contentious issue, but was eventually resolved.
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