The US debt ceiling debacle
Discussions regarding the US debt ceiling are ongoing and distressing to watch. This is a recurring theme, resurfacing every few years, but it never gets easier to understand because of the prominence of the US as a global superpower. The debt ceiling debate is clearly worsened by the fact that the US is more and more polarised, with both political parties digging in their heels based on party doctrine rather than common sense. Already, the looming reality of the Treasury running out of cash in the coming weeks is having a profound effect on the short end of the UST yield curve. Yields on one-month UST bills have tightened sharply because this is considered “inside the potential default window”, whilst yields on two month UST bills and longer have widened. The three-month UST bill is now yielding 64bps more than the one-month, and the six-month bill is yielding an unbelievable 171bps more than the one-year UST. @johnauthers discussed this in a #BloombergOpinion article on Monday morning entitled “Debt Ceiling ‘X-Day’ Is Closer Than the US Realizes”, and I suggest you give it a read if you are a Bloomberg subscriber.
Although the entire debt ceiling debacle is over-covered at this point, I thought I would weigh in by providing my views.
This recurring nightmare is political theatre and will likely get resolved, but there are questions around the short-term and longer-term collateral damage this drama does time and time again to overall confidence in the US, including damaging the credibility of both the US Treasury bond market and the US Dollar
Should it not get resolved and the US defaults on its debt, the damage would potentially be profound because it could splatter into markets that we cannot really envisage since a US default has never occurred. For example, what would be the effect on banks as far as deposit flows and funding costs? Corporates would undoubtedly have to pay more for Dollar-based borrowing, and this could undermine their creditworthiness. The effects would not be confined to the US. Many emerging markets countries with links to the US / US Dollar would see their cost of borrowing rise, troublesome since many of these countries have little room to manoeuvre. It is impossible to know how broad the effects would be until we see it.
Should the US default, I suppose holders of UST bonds/bills would eventually be made whole, so I see limited risk of loss. After all, the US is in the unique position – at least for the time being – of being able to print Dollars that will be readily received with open arms by global investors once the default passes. But will investors still be so eager, and what price will be extracted from this self-inflicted mess? Certainly, the Dollar will continue to lose market share as a reserve currency, and the US government will pay more for borrowing.
The Republicans that control Congress are battling with President Biden and his Democratic administration, with the Republicans wanting expenditures to be sharply cut in exchange for raising the debt ceiling, a stance being rebuffed by President Biden. This is the same discussion that occurs every time the debt ceiling reaches an impasse. How do we get through this? My recommendation – which I think is sensible for reasonable people (possibly eliminating many US politicians) would be:
Agree to gradually reduce the deficit over time through a combination of expenditure reduction and higher taxes (sorry, but that’s a sensible compromise), eventually targeting the holy grail of a balanced budget, and
Abolish the absolute debt ceiling and instead put in place some sort of dynamic mechanism that ties the amount of US debt to the size of the economy, meaning GDP.
Ah, it’s all so easy on paper but so politically polarising that I doubt the dysfunctional group of US politicians currently in office will ever agree on something sensible without first bringing the US to the brink of default.
If you’ve had enough, stop reading here. If you want to understand the issues more, keep reading because below as I have provided more context.
What is the debt ceiling and why does it matter? You can find out everything you need to know about the debt ceiling in “Q&A: Everything You Should Know About the Debt Ceiling” prepared by the Committee for a Responsible Federal Budget. This organisation is a nonpartisan, non-profit organization committed to educating the public on issues with significant fiscal policy impact, and their website is here. The Pew Institute also published a very good article on the growth of US government debt: “5 facts about US national debt”.
Why are we here? US government debt was $1 trillion in 1981, $5 trillion in 1986, $10 trillion in 2008, and is now approaching $32 trillion.
Of course, the US economy has grown over this period too, with GDP increasing from $3.1 trillion in 1981 to $26.1 trillion now. However, what is more relevant – similar to assessing corporate leverage – is the trend of the ratio of federal debt-to-GDP. This evolution has not been good for the US, with debt-to-GDP increasing from around 30% in 1981, surpassing 100% in 2012, and now standing at 120% (having peaked at 134% during early stages of the pandemic).
Within the G7, only Japan and Italy have higher debt-to-GDP ratios than the US, with the ratios of other countries in this elite group – led by Germany with a responsible 63% – lower. The US can get by with this when the government is functioning properly due to the unique status of the US Dollar as a global reserve currency, a position that might be significantly undermined should the current debt ceiling discussions reach an impasse. Also relevant is the percentage of annual outlays by the government that go to service the growing debt burden of the US, a function not only of the amount of debt, but also of the cost of such debt. In this respect, the story has been slightly better because interest rates have been declining – at least until recently – since the mid-1990s. According to the Pew Institute, debt service costs are around 6.9% of annual outlays currently, down from 15% in the mid-1990s. However, as you might expect, the cost of servicing the government debt is now slowly moving up as the Federal Reserve tightens monetary policy.
Periodically there have been occasions when Congress has had to increase the debt ceiling of the US, which is rather bizarrely an absolute number rather than a percentage of GDP or a figure tied to the cost of servicing the debt, both of which would make much more sense. On each occasion this has turned into political theatre, with an agreement being reached just before the Treasury can no longer service the US debt. I read somewhere that this has played out 68 times since 1960, so the US has had plenty of practice. Often when the debt ceiling is raised, it is linked to some sort of “balanced budget” objective embedded in the legislation which – of course – is never met. The current ceiling of $31.4 billion was fixed in a bill passed by Congress in December 2021. The Treasury has been funding the government (including debt service) pursuant to so-called “emergency measures” since January, a sort-of accounting manoeuvre as I understand it to buy time. However, it is expected that these emergency measures will have run their course by June or July, and the US Treasury will simply run out of money. Meanwhile, Republicans in Congress and the Biden Administration have both dug in their heels, and discussions aren’t even taking place although this deadline is looming.
How much does the US spend? The fiscal year of the US government runs from October 1 to September 30. For the year ended September 30, 2022, total outlays were $6.3 trillion and total incomings were $4.9 trillion, resulting in a deficit of $1.3 trillion. The actual deficit was significantly less than had been projected ($1.8 trillion) in the FY2022 budget. The last time the US ran a surplus was in the late 1990s/early 2000s under the Clinton administration. As you can see below, the deficits have ebbed and flowed without correlation to the party in power, although the deficit seems to have been worse when Republicans have held the White House (contrary to popular thought).
When will the Treasury run out of money? This is not known for sure, but estimates are in June or July. Apparently, this looks more likely to be in June now since tax receipts were less than expected on the recent US tax day (April 18th).
What happens if the US misses payments or fails to redeem its near-term UST bills? I’m not really sure of the answer to this, but I suspect the risk of investors in UST notes and bills eventually not recovering 100 cents on the Dollar is very, very low. However, payments would be delayed until the issue is resolved, an occurrence that would certainly represent unchartered waters. Nonetheless, this might largely be viewed as analogous to a technical default since the US can certainly meet its obligations. Although debt costs might increase for the US government and US Dollar borrowers, the collateral damage would likely extend to emerging market countries with formal or informal links to the US Dollar. In a nutshell, confidence would be greatly damaged for anything that is US. Perhaps one benefit – as silly as this sounds – is that inflation would certainly fall faster than otherwise. Having said this, let’s hope like hell it is not something we see unfold – let inflation come down another way!
What will happen just after a default (should it occur) is sorted? There is a lot being written (including by Mr Authers in an article referenced earlier) about the effects on prices of USTs because of actions of the Treasury General Account, or the TGA. Currently, the TGA – the deposits held by the Treasury at the Federal Reserve – are being depleted to keep the government running including servicing government debt. Once the crisis passes one way or the other, the TGA will need to be replenished which will involve unusually large government debt issuance that will both cheapen existing bonds (i.e. increase yields) and potentially crowd out private sector borrowing at least for a period of time. In other words, expect yields on USTs to increase once a resolution is reached.
What are the long-term implications for investors? Assuming a default is avoided at the last minute, this event still chips away at confidence in the US and everything US-related, including the cost of debt and the US Dollar. Will we look back in the autumn and forget about this? I’m not sure, because the political environment in the US is toxic, and there is no reason to be confident that the Republicans and Democrats will be willing to work together to deliver what is best for America as a country. Instead, both parties have tunnel vision and are nearly 100% focused on delivering what seem to be very different objectives largely driven by the extreme wings of both parties. I am not sure how this will end, but the discussion around the debt ceiling is a result of this division, not a cause of it.