Republicans and Democrats are squaring up for a fight over the US debt ceiling, and financial markets are nervously awaiting the outcome. In 2011, a politic clash over the debt ceiling and the resulting confrontation sparked equity market falls and an unprecedented downgrade for US debt. This time round, the stakes may be even higher, coinciding with uncertainty over Federal Reserve policy and the prospects of a weakening economy.
During this week’s event hosted by UBS Knowledge Network – The US is closer to default than ever – panelists warned the political confrontation, and market fallout, could come sooner than expected.
For now, US markets are in the calm before the storm, as politicians on both sides take positions and propose solutions to the looming debt crisis. John Savercool, senior lobbyist and head of UBS office of public policy said most ideas likely to be proposed in the next few months should not be taken too seriously.
The key moment, he said, will be the so-called X Date. “The X Date is the day the Treasury decides is the last day that it can continue to pay its debt obligations,” said Savercool, “After that, they would be in a stage of default.”
The timing of the X Date will depend on US tax receipts over the coming months. Pablo Villanueva, US economist at UBS, said recent financing estimates from the US Treasury suggest it may come sooner than expected. “Our estimate is that X Date will be reached at the end of July. But given this information from the Treasury, the odds of an earlier date in mid-July or even early June have risen.”
Savercool outlined what he believes is the plausible solution to the political stand-off. “There will be negotiations, the debt ceiling will be extended and there will be some modest deficit reduction reforms attached to the extension,” he said.
The Senate will be the main driver of those negotiations, according to Savercool. But once proposals move to the House of Representatives, matters could become trickier. It is possible, he warned, that some Republicans could use the moment to press for Kevin McCarthy to be replaced as House Speaker and such a vote would have to be taken at that same timer. "That could be a chaotic moment this summer,” said Savercool.
We have had the debt ceiling episode for many years over the last decade, but this one is particularly important because of the relationship between the debt ceiling with the Fed's balance sheet.
The US Treasury has already announced extraordinary measures to keep below the debt ceiling for as long as possible. Villanueva explained these extraordinary measures would include reducing non-marketable debt (debt the Treasury has with government agencies such as Medicare Funds and Social Security). At the same time, the Treasury would draw on its cash deposits in the Treasury General Account (TGA) at the Federal Reserve.
Villanueva, said: “We have had the debt ceiling episode for many years over the last decade, but this one is particularly important because of the relationship between the debt ceiling with the Fed's balance sheet.”
In the run up to the X Date, about $600 billion in cash will be drained from the TGA, said Villanueva. Then, once an agreement is reached to lift the debt ceiling, there will be an effort to rebuild that cash at high speed, probably over just 6-8 weeks. These substantial movements in the Fed’s balance sheet will come as the economic situation is likely to be weaker than today. Villanueva concluded: “Given this combination of factors, we think it more likely than not that that in June the Fed is simply going to say ‘OK, let’s stop Quantitative Tightening.’”
Meanwhile, investors and trading desks should be careful of making easy assumptions about how the debt ceiling debate will move markets, according to Mike Cloherty, UBS head of rates strategy.
“If we went over the edge, it would be very unsettling for risk assets,” he said. “On Treasuries, the thing to worry about is a downgrade storm. I don’t think any ratings agency wants to downgrade the US Government, but if we missed payments, they probably have to,” he added.
But Cloherty said a downgrade would not automatically mean a fall in the market price of Treasuries. In 2011, when S&P downgraded the US, Treasuries rallied. “A lot of funds have an average rating target,” Cloherty explained. “If you have a single A rating target and suddenly all your AAA becomes AA, you might have fallen below your average rating target. So, you will sell your lower rated securities and buy more higher rated securities.”
Despite the downgrade, Treasuries would still be the most obvious higher-rated assets and so, Cloherty argues, a ratings downgrade would damage lower-rated bonds more than Treasuries themselves.
“The protection here is everyone should hold a little more cash going into the X Date and buy those securities that look cheap,” he said.
Politics may be the starting point for the debt ceiling stand-off, but it is also likely to be the best hope for avoiding disaster. John Savercool explained: “Neither party wants to be blamed for another ratings downgrade. Obama was largely blamed for the downgrade in 2011 and that’s not something he is happy to have on his resumé. So, both sides are very sensitive about that, and it will add to the urgency of getting something done in a more positive way.”
