The U.S. reached its debt limit of USD 31.4 trillion on January 19th 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 U.S. debt ceiling. The U.S. reached its debt limit of USD 31.4 trillion on January 19th 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 U.S. 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 U.S. will default. Lawmakers have raised or suspended the debt ceiling over one hundred times since WWII and under every president since 1959. It is possible that political parties agree to a short-term extension or suspension of the debt ceiling and continue to negotiate over future spending. While budget negotiations may happen 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. One option is invoking the 14th Amendment, which states that the validity of U.S. debt shall not be questioned, but that is subject to legal interpretation and could get tied up in the courts. Another option is that debt payments could be prioritized, although it is unclear that operationally the systems and procedures in place are equipped for this. Finally, the Treasury could issue and deposit a trillion-dollar coin at the Fed in exchange for funds in the TGA. This proposal has been largely dismissed by central bankers. 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 U.S. 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 U.S. 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%. However, at the time, rates were at 0%, so the opportunity cost of holding gold was less than it is today. 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 U.S. dollar and gold, high quality core bonds may protect if volatility picks up. If volatility fails to materialize, 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.