In this article:
- Market pricing of US default risk is now higher than it was during the 2011 debt ceiling standoff, as reflected by spreads on credit default swaps.
- We see an 85 per cent probability that a last-minute deal will be reached. Macro implications would be limited but we would expect to see market dislocations both pre-deal (risk off) and after a deal is announced (risk on).
- We see a 15 per cent probability that no deal is reached. Potentially serious macro implications, driven by tightening financial conditions. See below for detailed analysis of various ‘no deal’ scenarios including invoking the 14th Amendment, or a prioritization of payments or default scenario.
How to quantify what’s at stake for investors in the US debt ceiling drama? Current market pricing suggests US default risk is now higher than it was during the 2011 debt ceiling standoff, as reflected by spreads on credit default swaps.
But there are many ways this standoff could unfold in the coming days. What follows is not intended as definitive, but rather is an illustrative attempt to handicap the probabilities of some of the potential outcomes, and to map out the market and macro impacts of the various scenarios.
On balance, we see an 85 per cent probability that a last-minute deal will be reached, whereby President Joe Biden’s administration and Congressional leaders agree to raise the federal debt ceiling, avoiding a sovereign default. The immediate macro implications of this scenario would be limited but we would expect to see market dislocations both before the deal is announced (when risk-off sentiment rises) and after a deal is confirmed (amid a shift to risk-on positioning).
On the other hand, we see a 15 per cent probability that no deal is reached. This carries potentially serious macro implications, driven by tightening financial conditions and heightened macro uncertainty. Our detailed analysis of various ‘no deal’ scenarios follows below, including unlikely cases in which Biden invokes the 14th Amendment, or a scenario where the US reverts to prioritizing payments to creditors (see Figure 1).
US Treasury Secretary Janet Yellen warned recently that the best estimate of the federal debt ceiling X-date (the date on which the Treasury has exhausted all extraordinary measures and cash reserves) could come in early June, potentially as early as June 1. That timing was affirmed by an estimate by the Congressional Budget Office. Subsequent meetings between Biden and the Speaker of the House, Republican Kevin McCarthy, and their staffers have started to show clear signs of progress. However, while negotiations seem to have now begun in earnest, any final deal between Biden and McCarthy could still be derailed if they are not able to sell it to their core constituents.
Assuming negotiations continue to make progress, we would expect a short-term extension to the debt ceiling to come through soon in order to buy more negotiating time. This is primarily because there is now very little time left in the legislative calendar to reach, draft, and pass a deal through both chambers of Congress before the late May recess.
Whichever immediate path is chosen though, some form of showdown is almost certain to occur between now and September. We see a last-minute deal as the most likely outcome. However, given the political polarisation both within and across the two parties, and the current gap between the two negotiating sides, it is highly likely that the process going forward will be noisy - and that any deal will likely come at the 11th hour, with pain in the markets likely required to make a deal possible.
While any of the outlined scenarios that results in a deal is likely to trigger a relief rally in markets, the macro implications for the real economy from any such resolution are limited. By contrast, either of the two ‘no deal’ scenarios would very likely add to the pressure on the unemployment rate, which we already expect to increase over the coming months due to monetary policy tightening that is already working its way through the system.
In the 14th Amendment scenario, which envisions the US government continuing to issue debt over and above the debt ceiling, the extraordinary uncertainty created by such a constitutional crisis will almost certainly lead to a selloff in financial markets until the Supreme Court rules. While we would expect the Supreme Court to eventually come down in the President’s favour, the time taken to get to that point (likely to be around four months) means the uncertainty and the shock to financial conditions will continue until that point. This will likely result in a temporary upward shock to the unemployment rate of around 0.5 percentage points.
In the payment prioritisation scenario, which would see the US Treasury attempt to prioritise payments to bond holders over social security recipients, the shock to financial market confidence from the ensuing fiscal drag and heightened uncertainty would be so severe that we would anticipate lawmakers would rapidly reverse course. Nevertheless, in such a scenario, we would expect the macro damage from this action to be largely irreversible and significantly greater than the 14th Amendment scenario. As a result, we would expect unemployment to rise by around 1-1.5 percentage points in this scenario.
Implications for asset allocation
The debt ceiling impasse of 2011, which triggered the loss of the US government’s AAA rating from S&P, offers a cautionary example for today. In the weeks following the downgrade in August 2011, US stocks fell by double digits and Treasury yields slid sharply (albeit the risk-off move was also compounded by the peripheral debt crisis in Europe).
While we see a ‘no-deal’ scenario as a low probability outcome today, given the political and economic costs, it is worth keeping in mind that US Treasuries serve as the benchmark rate for valuing financial and other assets around the globe. Should the full faith and credit of the US government come into question, the resulting disruptions would be highly damaging to markets and the economy globally.
At the moment, the US debt ceiling negotiations are a risk factor that we are monitoring closely. But the standoff is not among the most significant drivers of portfolio positioning yet, as we continue to expect that a resolution will ultimately be agreed.