The US reached its debt limit of USD 31.4 trillion on 19 January and has since been relying on funds in the Treasury General Account (TGA) and so-called 'extraordinary measures' to fund its obligations.
From the Federal Reserve (Fed) to banking sector weakness, investors already have a long list of risks to consider, to which they can now add heightened concerns around the US debt ceiling. The US reached its debt limit of USD 31.4 trillion on 19 January and has since been relying on funds in the Treasury General Account (TGA) and so-called “extraordinary measures” to fund its obligations. Initial estimates from the Congressional Budget Office (CBO) projected these measures would last until between July and September, but the CBO and Treasury Secretary Janet Yellen now expect the US could run out of funding by early June due to smaller-than-expected April tax receipts.
Still, it is not our base case that the US will default. Lawmakers have raised or suspended the debt ceiling over one hundred times since WWII and under every president since 1959. An unprecedented default would be politically damaging to both parties. It is likely that they agree to a short-term extension or suspension of the debt ceiling and continue to negotiate over future spending. While budget negotiations are important given high levels of debt and deficits and rising interest costs, the stakes should not be default.
Some are pondering alternatives to a debt ceiling deal, but most of these options are implausible. One option is invoking the 14th Amendment, which states that the validity of US debt shall not be questioned, but that is subject to legal interpretation and could get tied up in the courts. Another option is the Treasury issues and deposits a trillion-dollar coin at the Fed in exchange for funds in the TGA. This proposal has been largely dismissed by central bankers. Finally, debt payments could be prioritised, although it is unclear that operationally the systems and procedures in place are equipped for this. Therefore, the path of least resistance is suspending or raising the debt ceiling.
Although default is unprecedented, the best point of comparison for markets is the 2011 debt ceiling standoff and subsequent credit rating downgrade. As highlighted in the chart below, equities faced considerable volatility but, interestingly, Treasury yields fell. Some may have anticipated a rise in Treasury yields as US credit quality was in question, but yields dropped 120 basis points (bps) from one month before the debt ceiling agreement to one month following the debt downgrade. Part of this could have been anticipation of a recession as a result of the turmoil; it could also be attributed to safe haven flows. It should be noted that the flight to safety was likely amplified by the coinciding sovereign debt crisis in Europe. Importantly, there are no cross defaults of Treasuries, so even if there were a default, only the Treasuries that mature when the government runs out of money would default. This is why many money market funds have avoided T-bills that mature around the X-date to manage risk.
Traditional safe havens like gold and the US dollar also protected during the 2011 episode. Gold surged 10.8% in the month leading up to the agreement, topping out three weeks later, up another 15%. The dollar lurched 1.4% in the week leading up to the debt ceiling agreement but mostly reversed in the two weeks following the subsequent credit downgrade.
While some investors may choose to hedge debt ceiling risks through the US dollar and gold, high quality core bonds may protect if volatility picks up. If volatility fails to materialise, core fixed income should still be well supported by slowing economic growth and inflation, which are likely to weigh on bond yields in the coming months.