Ro'Macro #11: US to default in October?!
Janet Yellen warned that in October the US Treasury would be unable to face its payments if the debt ceiling isn't raised... How is that possible and why ?
Hi everyone! Welcome back on Ro’Macro and today we are talking about the debt ceiling of the United States. Before that, just type your e-mail below to receive all the news directly in your inbox !
As I wrote last time, it might be time to look to another area than the US… At first I wrote that mostly because of the under performance of other markets and the handling of the Covid-19, but now we have another reason that seems to be the most important now. It is not the first time this situation happened, in 2011 and 2013 we had the same kind of problems. As we’ll see below, this type of event is not really appreciated by the market.
1) Debt Ceiling Explained
Let’s start by a definition of the Debt Ceiling and a bit of history :
“The debt limit is the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments”.
The debt limit does not authorize new spending commitments. It simply allows the government to finance existing legal obligations that Congresses and presidents of both parties have made in the past.
Every week, the Government issue bonds in the markets to raise money. The problem is, there is a limit to that. Janet Yellen, Treasury Secretary said that if the Debt ceiling isn’t raised soon, the Treasury won’t be able to face its obligations around the 18 Oct. In the chart below is showing the US outstanding debt increasing, specially since the Great Financial Crisis after which countries started to issue even more with the loose policies of Central Banks. At the moment the debt ceiling is at $28’500 Trillions. As you can see, we are really close to this level.
Source : Bloomberg
When the limit is reached, there is still the possibility of using “extraordinary measures”. Here’s an explanation of what is it exactly :
The Treasury Department is permitted to borrow funds needed to fund government operations, as had been authorized by congressional appropriations, up to the debt ceiling, with some small exceptions. When the debt ceiling is reached, Treasury can declare a “debt issuance suspension period” during which it can take “extraordinary measures” to continue meeting federal obligations provided that it does not involve the issue of new debt. These measures are taken to avoid, as far as resources permit, a partial government shutdown or a default on the debt. These methods have been used on several previous occasions in which federal debt neared its statutory limit.
Extraordinary measures can include suspending investments in the G Fund of the Thrift Savings Plan of individual retirement funds of federal employees. In 2011, extraordinary measures included suspending investments in the Civil Service Retirement and Disability Fund (CSRDF), the Postal Service Retiree Health Benefits Fund (Postal Benefits Fund), and the Exchange Stabilization Fund (ESF). In addition, certain CSRDF investments were also redeemed early.
Extraordinary measures are by definition, temporary. This means US politics have to find a solution, otherwise it won’t be pretty. Why is that ? Because United States is the heart of the market, US Treasuries and more broadly USD assets are the first thing people are buying when things aren’t looking great because it’s the safest asset you can have in the world, this is why in stressed times we call buying those assets “flight to quality”. If the US default on its debt which would be unprecedented in American history, would have consequences. First a downgrade on US bonds, investors will sell their bonds and that will raise rates. Currently markets are very sensitive to change in rates, specially Nasdaq and tech (Higher the rates, the more you discount on earnings and Tech valuation rely on the fact they have high growth financed by low rates => high profit). In the last 10 days, the US 10y is 1.53, up from 1.35 10 days ago, that’s 14%. In the meantime, Nasdaq is down 4.5% so it’s already weighting on the market. Moreover, the biggest tech names represent almost 25% of the S&P500 which would emphasize the move if a sell off occur. Secondly, Mark Zandi, chief economist at Moody’s Analytics had some crazy numbers in his study if a default would happen. Those are the consequences he talk about :
- 6 million jobs that would push the unemployment rate to 9%
- $15 Trillion in household wealth
After all we’ve been through with Covid (And not out of the wood yet…), and again it’s “supposition”, but that doesn’t sounds really nice. The report even says “This economic scenario is cataclysmic. … The downturn would be comparable to that suffered during the financial crisis” Moody's Analytics
However, Congress has always acted when called upon to raise the debt limit. Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit – 49 times under Republican presidents and 29 times under Democratic presidents. Congressional leaders in both parties have recognized that this is necessary. See below the chart where you can observe debt ceiling and Federal debt growing together.
2) What stand in the way of doing it ?
Politics. We could basically stop there. Because politicians will push and try to make the situation to their advantage until their back are against the wall. They could even wait for the market to sell off before acting. US Debt surged $8 Trillion during Trump mandate, but Republicans do not want held responsible for raising the debt ceiling and therefore responsible for the growing debt of the country. Mostly because they have midterms in sight, to highlight how Democrates can’t handle the debt.
Having said that. what’s the current state of the solution? A bill has been proposed that keep the government open and raise the debt ceiling. It already passed the House but it needs to go through the congress. Where there is 100 people who vote. 50 Republicans, and 50 Democrats. The problem is, it needs 60 votes in favor to pass. Basically, it needs 10 Republicans to vote in favor of this bill, even if it’s not in their interest. Mitch McConnell, a republican said that most if not all his party won’t provide support to this bill.
It will hard for the Democrats to pass this bill, but ultimately, there is no other choice and they might need to to some concessions about spending, most likely about the $3.5 Trillion infrastructure plan of Joe Biden to make this go through and and avoid the consequences of a default.
3) What happened the last times the debt ceiling was reached ?
The debt ceiling has been reached raised/suspended dozens of times since it’s been created in 1917 but we’ll review what happened in 2011 and 2013. Those years are most recent and where it had the most impact on the market.
Let’s start with 2011. Soon after the new budget passed the debt ceiling was reached. On April 4th, the Treasury Secretary say in a letter that the extraordinary measures can be used to acquire funds. Those measures were implemented on May 16th. You can see in both chart below what the market started doing after that. The deadline was August 2nd, where US Treasury would exhaust its borrowing capacity. Still, it would have some cash to pay for its obligations, but analysts said at the time that it would run out of cash on August 10th. However, congress acted and it the end everything fell in place. BUT, look at what happened in July, with all the uncertainty this kind of situation brings, the S&P500 was down -17% between the top in July and first week of August.
Source : Bloomberg
Let’s take a look at 2013 now. It began in January 2013, when the United States reached the debt ceiling of $16.394 trillion that had been enacted following the debt ceiling crisis of 2011. Technically the debt ceiling was reached in December 2012 when Treasury started using extraordinary measures. To have a better idea of what happened and to look to correlation with chart, here’s the timeline of 2013 :
- On May 19, the debt ceiling was reinstated at just under $16.7 trillion to reflect borrowing during the suspension period. As there was no provision made for further commitments after the ceiling's reinstatement, Treasury began applying extraordinary measures once again.
- Despite earlier estimates of late July, Treasury announced that default would not happen "until sometime after Labor Day".
- On August 26, 2013, Treasury informed Congress that if the debt ceiling was not raised in time, the United States would be forced to default on its debt sometime in mid-October.
- On September 25, Treasury announced that extraordinary measures would be exhausted no later than October 17, leaving Treasury with about $30 billion in cash, plus incoming revenue, but no ability to borrow money.
I highlighted the biggest move on each chart but you can clearly see the correlation between the events above and what happened in the market.
Source : Bloomberg
Source : Bloomberg
In conclusion, I don’t think the US will default. It would be too much to handle at the moment, and for the record, at every moment, a default on US bonds would be terrible for the market. However, I don’t want to underestimate the possible stress in the market in the next 2-3 weeks if the Congress continue to play around. Every time the debt ceiling needed to be raised it was raised, but not without stress. But don’t get me wrong, you can see that in 2011 S&P500 was at 1300, we are at 4300 so it’s going well but we can’t ignore the fact the volatility rose by almost 200% in 2011 and 75% in 2013… Be careful.
Thanks for reading it, I hope you enjoyed !
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