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The US has maxed out its borrowing again, with the $31.4 trillion debt ceiling coming onto investors’ radar as a potential tail risk for the markets. No wonder: Memories of S&P’s 2011 downgrade of US government debt and federal government shutdowns in 2013 and 2018 suggest that partisan brinksmanship and rancor, culminating in another 11th-hour patchwork deal, are probably what we should expect from Congress this time around.
For added color on the political showdown in Washington, I recently spoke with US Macro Strategist Mike Medeiros.
First of all, the US debt ceiling is a critically important issue, not only in Washington, but also for the global economy and markets. Failure to raise it in a timely manner could have significant negative fallout, from default to downgrade and more.
The US Treasury has said that 5 June 2023 is the earliest possible date (the “X date”) for when the government could default on its debt obligations. While default is not my base case outcome, there are enough red flags early on in the process that warrant investors’ attention, given the potentially serious risks of Congressional inaction. In the current US political environment, the degree of polarization and mistrust between the two major parties, coupled with a narrow Republican majority in the House, pose a worrisome backdrop ahead of the upcoming debt-ceiling negotiations.
The distribution of potential outcomes remains wide, and my level of concern around the process of raising the debt ceiling is elevated. I think a Congressional agreement to form debt sustainability committees on a bipartisan basis is the most likely path and is currently being discussed in the Senate. The key would be whether or not these committees have any binding constraints, particularly a clear timeline with deliverables to ensure that the debt ceiling actually gets raised in a timely manner.
There are other possible paths: 1) One side “gives in,” with either Republicans agreeing to an unconditional debt-ceiling increase or Democrats acquiescing to some discretionary spending cuts; 2) President Biden raises the debt ceiling through executive order if, for example, Congressional negotiations fail and push the US government to the edge of default.
The market has assigned fairly low odds to a US government default, which makes sense to me given that there have been numerous debt-ceiling increases since 2011. Both parties, Democrats and Republicans alike, recognize that the consequences of doing nothing could be catastrophic for the US economy, not to mention the global economy and the financial markets. That’s obviously an undesirable outcome for which neither party would want to take responsibility, especially come election season. However, the stakes are much higher today, with US public debt now 127% of GDP. As Figure 1 shows, that’s more than double what it was in the late 1990s.
With Mike’s valuable perspective on the US debt ceiling, my base case as of this writing is that the prospect of a Congressional impasse will likely stoke market volatility in the short term, but that the debt ceiling will eventually be lifted (aided by mounting public pressure to do so). For now, I see several potential investment implications:
Higher credit-risk premium on US government bonds: Waning investor confidence in a timely resolution of the debt-ceiling quagmire would likely be reflected in a steeper US yield curve. Whether interest rates would rise (due to a larger credit-risk premium) or fall (given higher recession risk) is less clear.
A weaker US dollar, a boon for non-US risk assets: A perception that the US government is unwilling or unable to pay its debts would be a weaker currency story for the US dollar and could support non-US risk assets. That said, the US dollar remains the world’s dominant reserve currency, with global central banks holding around 60% of their reserves in greenbacks.
Defensive sectors more likely to outperform: Increased recession risk would likely benefit more defensive equity sectors, like healthcare, utilities, and consumer staples.
Upside for gold: A weaker US dollar amid a debt-ceiling battle in Congress would likely be supportive of gold prices, at least temporarily.
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