May 01, 2023
Investment Strategy Brief: The Debt Ceiling and Spinach
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Below is a transcript of this week’s video.
On January 19th Treasury Secretary Yellen announced that the U.S. had hit its debt ceiling. This is a key step in the flow chart of how the U.S. government funds its ongoing operations. Preferably, the government would fund itself through normal operations, turning a budget surplus, but this is often not the case. In fact, most governments, including the U.S. run a deficit, which must be financed by borrowing – issuing bonds to investors. But borrowing of this sort has a limit – often referred to as the debt ceiling – that is mandated by congressional legislation. When the debt ceiling is hit, the federal government is no longer permitted to issue new bonds to cover budget deficits. But the government does not immediately default. The Treasury has the latitude to employ extraordinary measures to avoid default without increasing debt by shifting government spending and postponing new investment. Of course this too has a limit since there are only so many other pockets to empty – after which, the Treasury can prioritize its payments to focus on the have-to’s – interest on its debt, social security, Medicare, and military. Discretionary spending, would, in theory, come to a halt. And only after once that no longer works, would the government run into a position of defaulting on its debt.
We are currently at the stage of the Treasury employing those extraordinary measures. A key question is how long will these last, and the opinion here seems to differ depending on the source. These extraordinary measures are estimated to last, most likely, until between late July and mid-August. The margin for error in early June, before quarterly estimate tax payments are received, is thinner than most would like to see.
Fixed income markets and their associated derivatives markets have already begun to reflect this risk. Importantly, credit default swaps, or CDS, on US treasuries, which are essentially insurance against missed payments have jumped upward. CDS rates have risen the more for 1-year Treasuries than 10-year Treasuries – likely reflecting the risk of a technical default – i.e. a missed or delayed coupon payment – rather than an outright default and non-payment of all interest and principal. A missed or delayed coupon payment means far more to a shorter-term bond investor than a longer-term bond investors where near-term coupon payments only make up a small part of the bond’s value.
The U.S. last faced a serious risk of default on its debt in 2011 – this period provides a preview of the potential impact of such an event. In 2011, while credit default swaps* initially spiked in the period leading into the potential default, bonds ultimately appreciated and yields fell throughout as the default did not happen and austerity measures were implemented. By contrast, it was the equity markets that declined, to the tune of nearly 15%. The resulting austerity improved the finances of the U.S. government at the expense of consumers and businesses.
This week, the House passed, along party lines, the Limit, Save, Grow Act of 2023 – a debt ceiling raise with $4.8 trillion in spending cuts. While the bill will admittedly be dead upon arrival in the Senate, it is still an important step along the legislative process toward a resolution to the debt ceiling. The House bill serves as a testament to the House Republicans’ ability to coalesce and deliver a successful vote. We are now at the stage marked by the yellow star when serious bi-partisan negotiations need to begin. With the House bill passed, the door is essentially closed for a completely “clean” debt ceiling bill, which will not receive the needed votes in the House, so the only possible path to resolution is some form of a negotiated compromise. This will not be an easy path by any means, but a path to resolution has been established.
Now, while the recent House bill is by no means the final bill, it likely serves as the starting point of discussions and its components are informative. First, there are only spending cuts – no tax hikes. Second, the proposal takes aim at some key Democratic initiatives and imposes a hefty discretionary spending cap. In short – looks like austerity to us. Again, this is not likely the final bill. According to our sources, the final bill will most likely end up with around $1.5 trillion in a combination of tax hikes and spending cuts – 20-25% the size of what the House just passed.
So to summarize:
- The U.S. officially hit the debt ceiling on January 19 and has been employing extraordinary measures to avoid default
- The U.S. Treasury can likely employ extraordinary measures into the summer, but the exact deadline remains in flux
- Bond markets and derivatives markets are already pricing in some chance of a technical default as short-term bonds are likely the most impacted
- During the previous cycle, equity markets were impacted just as much by default concerns as growing expectations of austerity
- The bill passed last week in the House is a step toward resolution of the debt ceiling, and like 2011, includes a heavy dose of austerity
In short, the debt ceiling debate is likely to become louder until a heathy dose of spinach (i.e., austerity) is taken.
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