The X Factor: Evaluating the U.S. Debt Ceiling

On January 19th the U.S. reached its $31.4 trillion borrowing limit and invoked extraordinary measures to fund the government. The onus is now on Congress to act before the X Date – the point at which the Treasury exhausts extraordinary measures – or risk an unprecedented government default. The stage is set for a contentious debt ceiling showdown that will likely precipitate elevated financial market volatility, but ultimately we expect the U.S. will avert a dire default. 

The debt ceiling (or “debt limit”) is the amount of money the U.S. government is authorized to borrow to meet its legal obligations. Albeit estimates are imprecise, between the projected debt accumulation for fiscal year 2023 and an estimated $400 billion worth of funds from “extraordinary measures”, many participants expect the X Date to fall between July and August (see Exhibit 1). Importantly, it is believed that neither party within Congress has a motivation to begin negotiations until we’re much closer to the X Date. Republicans likely have less leverage when the crisis point is months away, and Democrats seemingly have little reason to offer up anything proactively. This suggests that investors may be contending with this issue for some time and financial market volatility as the X Date approaches may be the necessary catalyst for a resolution. We find it unlikely that either side of Congress will choose to risk the unknown (but likely significant) consequences of a U.S. default, but there is reason to believe they will push us right to the edge of the cliff. We expect elevated financial market volatility – and will be closely watching Treasury bills maturing around the X Date for indications of the degree of market concern – but ultimately expect volatility to be short-lived as Congress finds a way to come to a last-minute resolution.

IS THIS TIME DIFFERENT?

Nearly every other country allows its debt level to move as a byproduct of legislature-approved tax and spending measures. However, in the U.S. the debt limit is an “extra step” that its proponents argue creates opportunities for fiscal reflection. Critics contend it is redundant and only leads to unproductive political bluster and uncertainty. To today’s investors, the debt limit’s efficacy is less important than whether or not Congress will successfully act to fund the government beyond the forthcoming X Date.

The debt limit originated over 105 years ago and Congress has since acted on it ~100 times. But while acting on the debt ceiling was once a somewhat straightforward formality, it has proven an increasingly tough task over the past decade-plus. Congress has managed to agree on a resolution to avoid U.S. default every time, but a look at several of the most recent impasses reveals it hasn’t always been without near-term pain as Congress often waits until the late innings when a “crisis” needs attending to:

1) The 2011 downgrade. In May of 2011 the Treasury began to deploy extraordinary measures and estimated an X Date in August. The split U.S. government struggled to find a resolution as the Republican House demanded a deficit reduction in exchange for a vote to increase the debt ceiling, while Democrats insisted against negotiations on the debt ceiling. In the final days before the X Date, an agreement was made to raise the debt ceiling through a two-stage increase designed to cut spending over the long run. A default was avoided, but S&P cut the long-term U.S. debt rating from AAA to AA+ on August 5, citing concern on American policymaking. 

2) The 2013 impasse. In May of 2013 the U.S. hit its debt limit and the Congressional Budget Office cited an X Date of sometime late in October. On October 16, a bill was signed that ended a partial government shutdown and also suspended the debt limit until February of 2014. With the 2011 downgrade relatively fresh in minds, this impasse brought a more visible response from the Treasury related to its concern on political brinksmanship and the consequences of default.

3) The 2014–2019 suspensions. From 2014–2019 there were a series of debt limit suspensions. Until 2016 the U.S. operated under a split government with a Democrat President (President Obama), but the suspensions generally came about without much difficulty – potentially because of debt ceiling “debate fatigue” from the 2011–2013 episodes. And while government was also split from 2017–2019, President Trump had little desire to use the debt ceiling to cut spending.

4) The 2021 punt. In October of 2021 Congress agreed to a minor raise to the debt limit that the Treasury estimated would fund the government until sometime in December. Shortly ahead of the December X Date, Congress raised the debt limit via a one-time pathway that allowed the Senate to raise it with a simple majority vote. While the Democrats had full government control, neither party wanted sole responsibility of raising the debt limit given voter concern on the deficit. The fairly minor increase merely “punted” the issue – setting the stage for this year’s showdown. 

For several reasons, the looming X Date has the potential to be the most contentious and disruptive debt ceiling episode since 2011. For one, the current composition of government is nearly identical to 2011 with a Democrat President, Democrat majority in the Senate and Republican majority in the House. Also as in 2011, House Republicans have made clear their intentions to seek major cuts, while Senate Democrats have made clear their intentions to not concede. Moreover, in order for recentlyelected House Speaker Kevin McCarthy to secure his bid, he had to make promises of significant fiscal reform that will likely encourage him to draw a hard line in negotiations with Democrats. Finally, the incentives are aligned for both parties to take late-inning action. The closer to the X Date, the greater the risk of adverse consequences – and the greater the risk of adverse consequences, the more leverage Republicans have to force Democrats to the negotiating table. Knowing Republicans have little incentive to entertain talks until the stakes are higher, Democrats have little incentive to begin engaging in what would likely be mostly unproductive discussions.

THE POLITICAL PATH FROM HERE

In order to raise or suspend the debt limit through regular order, 60 votes are required in the Senate to avoid a filibuster, while a simple majority is needed in both the Senate (50) and House of Representatives (218) to send the bill to the President’s desk. Currently, Democrats hold a 51-49 majority in the Senate, but Republicans hold a thin majority of 223-212 in the House. While it is uncertain that a “clean” agreement will be made wherein House Speaker McCarthy and six House Republicans capitulate upfront before negotiation, there are 18 House Republicans from districts that President Biden won that may provide an avenue. An agreement may also come in the form of a “compromise” bill, which would require concessions from both sides that allow each party to claim victory in some form. Notably, this solution is unlikely to come before the late innings, given the incentives we mentioned each party has to push off negotiations.

Absent a conventional agreement, a few other courses of action can be taken to avoid default. If House Speaker McCarthy refuses to put a bill on the floor, a discharge petition would allow the House to vote on it with a simple majority. However, this process could take months and would still require six Republican House votes plus full Democrat support. In the event the X Date passes, prioritization of payments by the Treasury is likely to avoid missed debt payments. This is an unproven option that the Treasury has denied is feasible, but theoretically the Treasury department may be able to push off a default by prioritizing its debt payments over other obligations. Without going into detail on each, we note there are several other unlikely, but potential, options for the Administration to act unilaterally to avoid default. Among others, these include use of the 14th Amendment, a platinum coin and perpetual bonds. Each of these are fraught with operational and legal hurdles that make them quite undesirable, and could threaten rating agency action on U.S. Treasuries. 

We are watching several key events in the leadup to the X Date (outlined above in Exhibit 2). The State of the Union address is scheduled for February 7th and President Biden may offer early remarks on debt ceiling negotiations. The President’s fiscal year 2024 budget request – likely to be released some time in February/March (last year’s was released in March) – is highly likely to spur a Republican Party reaction. Not too long thereafter the House budget is expected to be released, which should more clearly define requested budget cuts. When the Congressional Budget Office (CBO) releases its new budget projections – roughly estimated for some time in March/April – we should have a better estimate of the X Date. And April 18th is the deadline for federal income tax returns, which will also help better determine the X Date. Early June is the earliest possible X Date outlined by Treasury Secretary Janet Yellen, though most estimates hone in on the July/August timeframe as the more likely X Date, with some estimates going out even further. While X Date estimates are subject to shift, negotiations should ramp up a month or two prior to the perceived date. The financial market response should be more visible closer to the X Date, but any of the above events can produce a market reaction in the interim.

HOW FINANCIAL MARKETS MAY RESPOND

The X Date ushers in a time period where risk is elevated that specific Treasury securities may face technical default or delayed repayment of principal and/or interest if Congress does not come to some form of a resolution. Yields on Treasuries maturing just after the X Date often rise materially as investors price in this uncertainty. Similar to historical trends, we expect short-term yields will begin to rise as the X Date approaches later this year and investors take more caution against holding “at-risk” Treasuries (i.e., Treasuries maturing around the X Date). However, elevated short-term yield volatility until a resolution is passed should not be mistaken as a sign of unhealthy market panic nor a material change in investors’ long-term confidence in the Treasury’s ability to repay its debts. Treasury securities have long been viewed as a global safe haven due to several reasons including the size of the market, liquidity and stability of the U.S. economy. There is little reason to believe this will change as a result of U.S. debt ceiling negotiations. In fact, as shown in Exhibit 3, longer-term yields have historically remained stable – and at times declined – as the X Date approached. Even when U.S. debt was downgraded in 2011, longer-term yields declined as investors sought safety. We do not expect longer-term Treasury yields to break from historical patterns this go around, and believe interest rates will remain stable throughout the negotiation process, with risks tilted to the downside if anything.

Perhaps ironically, uncertainty around the 2011 debt ceiling and the subsequent U.S. debt downgrade helped U.S. investment grade returns. Per Exhibit 4, during the period 6 months before through 6 months after the estimated 2011 X Date, U.S. investment grade offered a pretty steady return stream and ended with a 9.6% gain. This topped U.S. high yield (6.0%), U.S. equities (4.9%) and non-U.S. equities (-7.3%). From this we glean the potential for uncertainty around debt limit negotiations to encourage a “flight-to-safety” mentality, with U.S. fixed income remaining a preferred source of safety. 

From the 2011 experience, we also observe the potential for material equity losses driven by volatility as the X Date approaches. However, as the issue is resolved and risks subside, equities can begin to claw their way back. Moreover, equity losses need not always accompany contentious debt impasses. Per Exhibit 5, equities rose somewhat steadily during the 2013 debt limit struggles. During the period 6 months before through 6 months after the estimated 2013 X Date, U.S. equities gained 20.3%, followed by non-U.S. equities (11.1%), U.S. high yield (6.6%) and U.S. investment grade (-0.4%).  

In the context of a U.S.-centric issue (raising the debt limit), it is interesting to see the outperformance of U.S.-based assets across both the 2011 and 2013 debt crises. In 2011, the performance of non-U.S. equities were impacted by Europe’s own multi-year debt crisis, which weighed most notably on Europe equities but also emerging markets. Alternatively, in 2013 emerging markets were the drag on non-U.S. equity performance as Europe performed well. In any case, the 2011 and 2013 episodes demonstrate that U.S. assets are not necessarily disadvantaged during U.S. debt impasses as investors attempt to look beyond any near-term disruption and position based on the longer-term fundamental outlook. 

A $31 TRILLION PROBLEM?

Absent disruption from debt limit impasses, we view the massive ($31 trillion) U.S. debt level as a low financial market risk. Indeed such a large number is reason for pause – especially given it has more than doubled twice since 2000 and debt to gross domestic product (GDP) has steadily risen from 53% in 2001 to ~125% today (Exhibit 6). However, we believe the debt to GDP comparison falls short. Debt is a stock of everything the government owes, while GDP, a measure of a country’s output across a given period, resembles a flow. Rather than compare a stock to a flow, we prefer to evaluate debt (a stock) against net worth (a stock). Debt to net worth sits around 20% and has fallen over the past decade. By this metric, the ability of the U.S. to service its debt does not appear nearly as problematic.

We also note the rather insatiable demand for Treasuries over the past decade. Certainly, such strong Treasury demand – even at historically low yields – does not point to investor concern on the U.S. debt load. Finally, it is important to consider the sequencing in the event that the U.S. debt load becomes too big to service. Such a scenario would likely take a major global crisis, and under such scenario it is difficult to imagine Europe and Japan avoiding their own debt issues first. With other nations at risk, Treasury yields would be in a position to actually move lower. 

All that said, we do view the U.S. debt load as a chronic issue for the economy. A crisis would be a sudden rise in interest rates that creates a debt service problem – something we don’t expect in the near term. What we do expect, however, is a higher level of inflation over time that equates to higher interest rates than the exceedingly low rates experienced since the financial crisis. The combination of higher debt levels and higher interest rates puts upward pressure on debt service costs – crowding out future government spending or necessitating higher taxes. Each represents drags on economic growth over time. So, while the current level of debt is low on our roster of current financial market risks, it does represent a headwind to growth and creates the opportunity for financial risks in the future. 

CONCLUSION: A SHAKY PATH TO A WELCOMED RESOLUTION

The stakes are high for upcoming debt ceiling negotiations. A U.S. default could send unprecedented shockwaves across the global financial system and leave markets in uncharted territory. While the extent of the consequences are uncertain, it is understood that they are in nobody’s best interest. We find it unlikely that either side of Congress will take the U.S. financial system right off the cliff. But, there is reason to believe they will push us right to the edge. We expect elevated financial market volatility – and will be closely watching Treasury bills maturing around the X Date for indications of the degree of market concern – but ultimately expect volatility to be short-lived as Congress finds a way to, once again, come to a last-minute resolution that skirts the undesirable consequences of a U.S. default. 

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