U.S. debt ceiling talks: what are the investment implications?

Default would be 'catastrophic' and even a last-minute resolution will impact markets

U.S. debt ceiling talks: what are the investment implications?

Representatives for U.S. President Joe Biden and the U.S. Congress’s Republicans ended another round of debt ceiling talks yesterday with no signs of any progress with the deadline to raise the government’s $31.4 trillion borrowing limit or risk going into default now only a week away.

Investors are growing more concerned about the implications of the government defaulting, which Treasury Secretary Janet Yellen has warned could be as soon as June 1. But commentators are also watching the political drama with interest as they parse the nuances of what could lie ahead. 

“Even though debt ceiling negotiations are not new, this is the furthest apart the two parties have been with peak acrimony,” said Christine Tan, AVP of portfolio management for SLGI Asset Management.

“Our base case is still a resolution, albeit it could come at the eleventh hour. Or we could see a ‘temporary’ suspension of the debt limit to allow more time for both sides to agree. The cost of not resolving this is much too high and may even trigger a further downgrade of the U.S. credit rating.”

Tan noted that the U.S. has run a deficit since 2002, although it was much smaller then.

Since 2011, when the U.S. credit rating was downgraded from AAA to AA+, the debt ceiling has either been suspended or increased annually. The debt ceiling then was $14.3 trillion, less than half of what is today.

The U.S. hit its current debt ceiling on January 19, 2023. Since then, Tan said the U.S. Treasury has been using extraordinary measures to keep paying its obligations and avoid a default. It has been temporarily ending, or reducing, some government investments to pay its bills. But Yellen has warned that it could run out of cash on, or about, June 1.

The Republicans, meanwhile, are using the opportunity to try to get spending cuts and structural budget reform. Biden has indicated that the debt ceiling impacts spending that has already been approved. He’s not willing to tie future spending budget discussions to the debt ceiling.

“It’s widely recognized that an outright default would be catastrophic for U.S. Treasuries, which have enjoyed low borrowing costs for decades,” said Tan. “Negative outcomes of a default could include stock market volatility, frozen federal benefits (Medicare, Social Security, and Medicaid), delays in federal wages, and an increase in borrowing costs as Treasuries lose their safe haven status.”

Tan is still betting on a last-minute deal – perhaps with caps on certain government spending categories in return for an increase in the debt ceiling.

But, with the June 1 deadline now only a week away, Eric Lascelles, the chief economist for RBC Global Asset Management, said the most likely scenario is that the government will prioritize certain payments over others if a deal is not reached in time.

“Debt payments – interest and principal – would likely be prioritized over other expenses, avoiding a technical default. The government would have to cut back on other spending, potentially including such areas as government payrolls and even pension payments,” he said, noting that government workers were not paid during brief government shutdowns in 2018 and 2019.

Still, government bills that mature just before June 1 are trading at a premium, while those maturing right after it are trading at a notable discount, especially since the situation is more serious than usual. That’s because of the divided Congress and the fact some Republicans have promised not to change the debt ceiling.

Lascelles noted there is also some risk, if there was a default, that some U.S. money market funds could lose enough money that their valuation could fall below par. If investors responded by selling their money market funds, it could force the funds to sell a wide range of short-term securities, causing distortions elsewhere.

He added that prominent pundits think there’s only a 1% to 3% risk that the U.S. government will default on its debt. Even if it did, it would repay it as soon as the debt ceiling was lifted.

But there could still be financial market risks, which could send risk assets lower and bond prices higher. There’s also a concern that many corporations that hold their cash in Treasury bills could suddenly not have the cash they need when they need it, creating a cascading effect in the economy. But he argued that any default could be quite short and, “any market weakness in response to debt ceiling issues should, arguably, be viewed as a buying opportunity.”

Lascelles expects there to be a liquidity drain on the economy once the debt ceiling has been dealt with since the Treasury may be in a hurry to issue a lot of debt so it can return to normal functioning and replenish the reserve funds that have recently been drained.

“This means quite a lot of money will suddenly be sucked out of the economy and into government coffers,” he noted. “That could send yields higher and have a modestly negative impact on the economy”.