US debt: Dancing on the ceiling
Back in 2018/19, UK investors (and global investors looking at the UK) had to get their heads around parliamentary legalese such as “prorogation”, “royal assent” and “the Salisbury convention”. Now it’s the turn of the US, as Congress goes through the saga of preventing the federal government from defaulting on its debt. Filibuster, reconciliation and cloture are the unwieldy terms to try to understand.
First, a bit of background. The US federal debt ceiling was introduced in its current form in 1941, and it has been raised over 80 times since the early 1960s. What used to be part of the routine business of government has become a political football in recent years. Since early August, the US has been bumping up against its legally mandated debt limit once again.
We were told last week that space under so-called “extraordinary measures” will disappear by 18 October, although there have been more recent suggestions the deadline may be slightly later in the month. Republicans and Democrats are locked in a political battle over how to increase the ceiling.
It’s the widespread expectation in the market that, by hook or by crook, the debt ceiling will be raised in time. The easiest path to get there is the Democrats agreeing to vote it through via reconciliation: a Congressional device that bypasses the need for a super-majority in the Senate. However, that is a convoluted process which is estimated to take 10 days of Congressional time to go through. Democrats, led by President Joe Biden, are adamant they won’t go down this route.
Alternatively, 10 Senate Republicans can agree to a “cloture vote” that would have the same effect of ending debate. But unlike the reconciliation route, this can happen in a single day. Republicans, led by Senate Minority Leader Mitch McConnell, are adamant that they won’t go down this route.
Hello, irresistible force; meet immovable object.
If both those attempts fail, the administration has various nuclear options to consider, including abolishing the filibuster altogether or invoking the 14th Amendment (which states, “The validity of the public debt of the United States, authorized by law … shall not be questioned”). These would almost certainly be subject to legal challenge.
So, what if? What should we expect if we wake up one morning in late October, and the deadline has passed without Congressional action? Brookings has provided a useful primer. Under the plan laid out in 2011, there would be no delayed payments on Treasury securities. Instead, payments to “agencies, contractors, Social Security beneficiaries, and Medicare providers” would be suspended. Those cuts would be brutal, requiring a 40% reduction in non-interest payments overnight.
An October 2013 study from the Federal Reserve assumed that a month-long impasse in which interest payments were prioritised in this way would see equity markets down 30% , 10-year yields up by 80 basis points, the US dollar down 10%, and BBB credit spreads 140 basis points wider.
We can definitely question their assumptions. The most suspicious bit of that analysis is the assertion that Treasury yields would rise sharply in the face of a huge fiscal tightening. When the US government was downgraded by S&P in August 2011, US 10-year yields promptly fell by nearly 70 basis points in the space of a few weeks.
It is also hard not to be reminded of the Brexit impact assessments published by the likes of NIESR and the UK Treasury in the first half of 2016, which confidently predicted a 40-100 basis point increase in gilt yields should the UK vote to leave the European Union.
Lionel Richie clearly enjoyed “dancing on the ceiling” but, even allowing for these caveats, financial markets almost certainly won’t. Given that economic self-harm on this scale is unlikely to win anyone re-election, we believe that this issue will be resolved. But if there’s no progress in the next fortnight, expect nerves to start jangling.