The U.S. Debt Ceiling Clock Has Started

• When Is the X-Date?
• If the U.S. Passes the X-Date
• Some Perspective Might Be Helpful
• What Investors Can Do Now

Investors have started to zoom in on downside risks as the US Treasury Secretary Janet Yellen said last week the country reached its $31 trillion debt limit and must invoke extraordinary measures to fund government operations and issue debt. This sets the clock for investors toward the so-called X date when the government could enter default and spark losses in the bond market. Let's take a closer look.

Extraordinary measures are government accounting maneuvers with no impact on the government's budget or economic growth. It's part of the Treasury's playbook, used before to continue funding the government while Congress negotiates setting a higher debt ceiling, often with some political drama. The government can continue to issue debt but only to a finite amount. Once that amount has run out, the government reaches the X date, which has never happened, and could enter default. Yellen last week cited June as the X date. Though, that may be intentionally conservative to create urgency. We think investors estimate the timing around July or August.

This debt ceiling episode could prove the most disruptive since 2011, when credit rating agencies downgraded Treasury bond ratings. We think the recent prolonged battle to elect the Speaker of the US House of Representatives may make negotiations to raise the debt ceiling particularly arduous. If a political battle causes the US government to slip past the X date, the Treasury could prioritize interest payments over other obligations. But it's unclear whether the Treasury has the power to do this and whether investors will find it reassuring if they do. It would be truly uncharted territory.

US stock market performance before and after debt ceiling conflicts, such as in 1995, 2011, and 2013, is mixed, but the key worry is a repeat of 2011 where the S&P 500 index fell 15% over just 10 days post deadline. Of course, there was an almost 25% pullback for stocks of companies with the highest sales exposure to US federal spending. So without question, the debt ceiling needs to be watched carefully to see how it unfolds this time.

For now, we don't see any meaningful risks in the market with the start of extraordinary measures. But we think the risk of a credit rating downgrade to government debt, as occurred in 2011, bears watching this time around as well. The practical implications of a credit downgrade are not entirely clear, but we don't expect a modest downgrade to result in market disruptions for treasuries, US Agency debt, or overnight repurchase agreements.

That being said, uncertainty around a downgrade will almost certainly unnerve global markets, at least temporarily. What all this tells me is that there's a greater likelihood of volatility ahead, as neither Democrats or Republicans have any interest in negotiating at this point. This is naturally going to lead to greater uncertainty as we approach the fall and the X date becomes more clear.