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Investment Strategy

May 15, 2023

Investment Strategy Brief: Knocking on the Debt Ceiling

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Below is a transcript of this week’s video.

Earlier this year, Treasury Secretary Yellen announced that the U.S. hit the debt ceiling, which is a key threshold in the flow chart of how the U.S. government funds its ongoing operations. While the government could fund itself if it maintained a budget surplus, the U.S. currently runs at a steep deficit, which must be financed by borrowing (in other words, issuing Treasury bonds). But borrowing capacity has a limit – often referred to as the debt ceiling – which is mandated by law. When the debt ceiling is hit, the federal government is no longer permitted to issue new bonds to cover budget deficits. However, the Treasury has the latitude to employ extraordinary measures to continue paying expenses 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. Once that point is reached, the Treasury has a decision – it can default or prioritize its payments to focus on the essentials, including interest on debt, Social Security, Medicare and defense.

This is important because the clock is ticking on how long those extraordinary measures can last. Yellen has cautioned Congress that the X-date, when the Treasury’s cash runs out, could occur as early as June given the uncertainty of timing and magnitude of tax receipts. It’s possible that they can make it until quarterly tax payments start replenishing federal coffers this summer. That could buy time until August, but the margin is appearing razor thin. Thus, the renewed urgency from the administration and Congress to figure out a deal to raise the ceiling.

Given all that, it’s important to set straight a common misconception here, in that this X-date is not the D-date, in this case referring to default on U.S. debt. Even in the scenario where the Treasury’s account runs dry, it still has incoming cash flows that can be used to pay some expenses. At current annual run rates, the federal government has enough cash flow to cover net interest costs, Social Security, Medicare, defense and veterans and health benefits. This suggests that the actual likelihood of default on Treasury debt is quite low, even if negotiations run past the so-called X-date.

Where does that process stand? Well House Republicans were able to narrowly pass a debt ceiling bill through its chambers that included several provisions for reduced spending going forward. This was a key step because it forced all parties to the negotiating table. The White House and Congressional leaders met last week to discuss the issue, which kicked off staff-level negotiations to bridge the partisan gap. Though they planned to get together again last Friday, the meeting was postponed to this week. Where things go from here remains to be seen, but it finally seems some urgency is setting in on this issue in Washington.

Looking forward, history tells us that we may be in for a changing regime on fiscal policy. The nonpartisan Congressional Budget Office estimates that, at current spending levels, federal interest costs are set to rise from 10% of tax revenues to 20% over the next decade. The last time U.S. debt burdens reached such levels was in the mid-1980s and early-1990s, during which several major acts of Congress were passed to rein in deficit spending. This time around could be similar, as a period of fiscal austerity may be on the horizon to address rising interest cost burdens.

The last time the debt ceiling was such a contentious issue, we saw a similar process playing out. Almost paradoxically, the S&P 500 started noticeable decline after the debt ceiling was raised, not before. Why did this happen? One reason may be the digestion of the reduced deficit spending that came with that debt ceiling raise. That can be a big deal, since government spending roughly accounts for a little less than 20% of GDP in the U.S. All else equal, a tightening of the purse strings reduces aggregate demand in the economy and is a headwind for profits.

In summary, the Treasury is currently employing extraordinary measures to avoid default after officially hitting the debt ceiling earlier this year. How long that can last is up in the air, though the most conservative estimate suggests early June may be the deadline to act. With that said, the actual risk of a default on U.S. debt, even if negotiations run past that date, is quite low given that the Treasury will still have enough cash flow to cover interest payments and other key outlays. The political negotiations appear to have begun – the House bill was a first step in that direction, but given the trajectory of deficit spending, some form of austerity that pulls back on fiscal policy may be in the cards. But overall for investors, as this issue continues to fester, equity markets could see some volatility in the near-term, stemming from angst around the approaching X-date and/or the implications of austerity.



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