09 Feb 2023

LGIM: US debt deadlock: what happens next?

With a repeat of the 2011 US debt ceiling showdown increasingly likely, we give some answers on how an agreement could be reached.

Another impasse over US borrowing could cause significant market disruption at a time when the economy may already be slipping into recession. But an outright default remains a very low probability event.

The current debt ceiling has now been reached, and the Treasury is using temporary measures to fund deficit spending. Absent Congressional action, the US will default on its obligations later this year. This is known as the X date.

Unfortunately, the path to a political agreement is narrow.

Why is the debt ceiling more of a problem now?

The politics have become even more divisive. The debt ceiling requires agreement from the House and Senate. Following the mid-terms, the Republicans have a very slim majority in the House. To gain the support of the more conservative members of the party, Speaker of the House of Representatives Kevin McCarthy reportedly promised to fight for large cuts to federal spending; the debt ceiling is one way to do this.

What is the path to an agreement?

It's extremely unclear – Democrats want a clean debt ceiling increase, having already agreed and delivered on their spending priorities over the prior two years. Raising the debt ceiling should be a formality, in their opinion. Republicans will push for spending cuts. They are keen to reverse some of the (non-defence) spending increases delivered under a Democrat-controlled Congress and White House over the previous two years. Step one is whether Republicans can even reach an internal agreement on the spending cuts to go alongside a debt ceiling increase. Then we will have brinkmanship between the House and Senate as they negotiate the scale of spending cuts. If the House fails to pass a debt ceiling increase, the clock runs out until the pressure to pass the debt ceiling increases.

What about a discharge petition?

This would require a small number of Republicans to oppose the party leadership and 218 signatories at least a month before the X date. It is not clear if Republicans would defy the leadership unless the situation is looking dicey. But by then it is too late to go down this route. After initially looking like a viable route to resolve the debt ceiling, both sides now seem to be digging in for a fight.

When is the X date?

Somewhere between June and November. There is a wide range of opinion at present. This complicates the Congressional response since at the moment there is no urgency or timeline to focus on. If the economy turns down sharply, the date will be earlier as tax revenues will disappoint.

What happens when the X date is breached?

Principal and interest payments will continue to be made on time. But the Treasury will have to take daily decisions about which other government payments to make. Rating agencies may consider spending failure a ‘technical’ default. This contraction in government spending could take 5-10% off GDP (on an annual basis) – a much bigger impact than a government shutdown. The increase in uncertainty and hit to confidence in government policy making could trigger a deep recession (I expect the economy to already be in recession).

Can executive actions avert the debt ceiling?

Invoking the 14th amendment to force the Treasury to continue paying the debt has been ruled out by Secretary of the Treasury Janet Yellen. An extreme option would be to mint a trillion-dollar coin (to deposit at the Federal Reserve in exchange for cash). Again, Yellen has voiced opposition.

Could there be short-term agreements to buy time for a deal?

It’s possible, but impossible to give a probability. Some Republicans might be keen to align the X date with a government shutdown, but this is hard to time precisely since it resets the temporary measures that the Treasury can use.

What would an eventual deal look like?

There is likely to be some austerity. This is what happened in 2011, and was one factor behind the negative equity market reaction as it discounted a weaker growth path. The long-term budget outlook is dire, with interest expenses set to surge. The Congressional Budget Office projections to be updated later this month will paint a far grimmer budget situation given the much higher path for interest rates than the projections made early last year. This will also be fuel for conservative Republicans to insist on budget cuts.

Disclaimer: Views in this blog do not promote, and are not directly connected to any Legal & General Investment Management (LGIM) product or service. Views are from a range of LGIM investment professionals and do not necessarily reflect the views of LGIM. For investment professionals only.

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