Congress is taking debt-ceiling negotiations uncomfortably near a vague but fast-approaching deadline that is closely monitored by markets. It’s not clear exactly when that deadline will arrive or exactly what will happen if it does. But from Wall Street to Washington there is fear that the fallout could be very bad.
The debt ceiling is “a doomsday machine and ought to be dismantled,” said David Kelly, chief global strategist for the asset-management business of the nation’s biggest bank, JPMorgan Chase & Co., in a phone interview.
The contraption itself was built by federal lawmakers during World War I, granting the U.S. Treasury the ability to issue bonds without congressional approval, but only if the total debt of the federal government stayed under a specified ceiling. Congress has raised the debt limit dozens of times since then, but in recent years the maneuver has become fraught due to the deep political divide in Washington and across the country.
Treasury Secretary Janet Yellen has warned the U.S. could hit its $31.4 trillion debt ceiling as soon as June 1, which would mean the U.S. government could potentially run out of cash if Congress fails to lift the limit. Members of the Republican and Democratic parties have been battling over including spending cuts as a condition for raising the borrowing limit, putting the Treasury Department in the position of possibly having to prioritize which payments it continues to make if a deal isn’t done in time.
President Joe Biden had for months insisted that Congress send him a “clean” debt-limit increase and present its arguments for curtailed federal spending as part of the annual budgeting process.
“ ‘They’ve taken the wrong hostage here. If you’re going to take something hostage, take the overall budget hostage, not the debt ceiling.’ ”
— David Kelly, JPMorgan
But what would actually happen if the debt ceiling were to be breached? It’s not clear exactly when or how it might happen. Experts say the government might not actually default on its debts, but they also worry about the immediate negative economic impact and the long-term consequences for America’s economic strength. Unpacking the damage the doomsday machine could unleash is tricky because it has never been set off.
“I just don’t like this game of chicken because they keep on pushing closer and closer to a point where one miscalculation, or one piece of foolishness, could end up putting you in a very serious situation,” said JPMorgan’s Kelly, adding that he anticipates the U.S. would not actually default on its debts in such a situation.
For Kelly, the underlying problem is that the debt ceiling is being used by politicians to demand concessions or, alternatively, “we will blow up the financial world.”
“They’ve taken the wrong hostage here,” said Kelly. “If you’re going to take something hostage, take the overall budget hostage, not the debt ceiling.”
The deadline itself is tough to pin down with certainty so it’s commonly referred to as the X-date. Concerns that its arrival is imminent have emerged in some corners of the market, such as trading of one-month Treasurys TMUBMUSD01M,
“The U.S. will not default on its debt,” said Bob Elliott, co-founder, chief executive officer and chief investment officer of Unlimited Funds, in a phone interview. “Treasury will do everything in their power to ensure that doesn’t happen.”
While Yellen has said the U.S. could run out of money as soon as June 1 if the debt ceiling is not raised, that deadline could end up being further out, according to Elliott.
Although possible, the probability of hitting the debt ceiling on June 1 is “pretty low,” he said. The Treasury may make it to mid-June, at which point it will receive quarterly tax payments that might see it through to the end of the month, when it could unlock more than $100 billion of “extraordinary measures” that potentially push the x-date to the second half of July, said Elliott.
Meanwhile, Yellen has conveyed a sense of urgency for Congress to act.
Financial markets would be in “uncharted territory” if the Treasury had to miss some of its payments because of the debt limit, and it’s not hard to imagine a negative reaction, said Alec Phillips, chief political economist at Goldman Sachs Group, in a phone interview.
But the economic consequences of failed payments, including to areas such as Social Security benefits or to military and federal employees, represent the “bigger risk,” he said.
For the most part, Treasury payments beyond debt obligations are “ultimately” going to individuals who use them to consume goods and services and “to pay their own bills,” said Phillips. The economy is driven in large part by consumer spending. Missed payments by the Treasury would risk “imposing some real economic damage,” with consequences beginning to build up after a few days, he said.
The U.S. economy has been slowing, with the Department of Commerce estimating in late April that gross domestic product expanded at an annual 1.1% pace in the first quarter. It wouldn’t take much to tip the U.S. into a recession, said Phillips.
“This would be a self-inflicted economic issue,” he said of consequences that would stem from the debt-ceiling breach. But that means “there’s a limit to how bad it gets,” in his view. “If it gets bad, somebody will fix it,” he said.
Defaulting by failing to make an interest payment because of the debt ceiling would be “catastrophic,” as Treasurys are the benchmark, “risk-free rate” in financial markets, according to Noel Dixon, global macro strategist at State Street Global Markets.
The $24 trillion Treasury market is backed by the full faith and credit of the U.S. government.
“If Treasurys are put into question,” Dixon said in a phone interview, “I don’t see how the system could function, frankly.”
The U.S. government bond market is the world’s “most liquid and efficient fixed-income market,” with an average $590 billion of U.S. Treasury bonds traded each day in 2022, according to a recent Coalition Greenwich report commissioned by SIFMA. This year, on March 13, “a record $1.49 trillion of U.S. Treasury bonds were traded in a single day.”
Treasurys holders include pension funds, mutual funds, banking institutions, individuals, state and local governments and insurance companies, as well as foreign governments, the report shows. “Large governments and individual investors around the world continue to see U.S. government debt as a sure thing, hence, the status of U.S. Treasury rates as the risk-free rate,” Coalition Greenwich said in the report.
Treasurys are also put up as collateral in repurchase, known as “repo,” agreements, which are used for short-term borrowing, said Dixon. A situation in which Treasurys were losing value because of a default could present a “nightmare scenario” in the repo market, he said. “Credit could seize up significantly.”
Repo-market participants include financial institutions such as banks, insurance companies, mutual funds, pension funds and hedge funds, according to a SIFMA report last year.
The ripple effects of a default on Treasurys could also include the drying up of corporate credit lines, said Dixon. “You would just have a massive seizing of the system.”
But Dixon is not expecting the Treasury to miss any interest payments due to the debt ceiling. “Even if we have a hiccup, I don’t think they think we’re going to default in the end,” he said. The thinking is, “we will pay our debt, one way or the other,” said Dixon. “We’re good for it.”
He expects investors may keep buying Treasurys, bidding up the prices of U.S. government bonds despite concerns over hitting the debt ceiling.
That’s what happened during the debt-ceiling drama in 2011, as the country then neared its X-date. Investors sought safety in the 10-year Treasury note TMUBMUSD10Y,
“It’s counterintuitive, but, ironically, what would probably happen is that investors would be selling stocks and moving into Treasurys,” said Goldman’s Phillips, “despite the fact that the debt limit is, in theory, something that would affect Treasurys.”
In late April, Fitch Ratings warned that the debt-ceiling showdown in Congress risks hurting the U.S.’s credit rating.
“If, ahead of the X-date, we were to assess the risk of a default as having become more material,” said Fitch, the country’s AAA credit rating would probably be put on “rating watch negative” and “further rating action could be considered.”
Early this month, Moody’s Investors Service said in a report on U.S. political risks that in the “highly unlikely” event that the country defaults by missing an interest payment, the ratings company would downgrade its rating. Moody’s rates the U.S. AAA, with a stable outlook.
A wide range of U.S. debt issuers, including financial institutions and nonfinancial companies, “would be affected by a sovereign rating downgrade, depending on the extent of their economic or financial exposure to the sovereign,” Moody’s said in the report, dated May 4.
In 2011, debt-ceiling brinkmanship led S&P to downgrade the U.S.’s credit.
From the archives (August 2011): U.S. stocks open sharply lower on credit downgrade
But S&P’s downgrade wasn’t particularly important in the sense that Treasurys continued to be treated as a unique asset class, said Phillips, as what mattered was they’re securities “backed by the full faith and credit of the U.S.”
“We don’t think that the odds are very high at all that the Treasury would fail to make debt-service payments,” he said, partly because of contingency plans put in place in 2011. Federal Open Market Committee transcripts that year indicated that the Treasury Department was planning to prioritize servicing its debt, said Phillips.
Still, JPMorgan’s Kelly warned in a note early this month that “political posturing” could increase investor nervousness about the debt ceiling, with the potential for equity-market volatility to rise.
The CBOE Volatility Index VIX,
“In theory, a threat to credit-worthiness of federal debt should boost Treasury interest rates and depress the dollar,” Kelly wrote in his note. But, he added, the traditional safe-haven roles of both Treasurys and the dollar make this effect “less certain.”
Adam Stern, co–head of research at Breckinridge Capital Advisors, told MarketWatch in an interview in late April that “as the financial markets get more skittish, it’s more likely to focus the mind of Congress to resolve the problem.” He said that “it’s kind of a Catch-22.”
House Speaker Kevin McCarthy said on May 16 that, while he and President Biden were still far apart in debt-ceiling talks, it was possible to get a deal done by the end of the week. Biden said in a speech at a separate White House event that he’s cutting an upcoming overseas trip short “in order to be back for the final negotiations with congressional leaders.”
Congress would probably suspend the debt ceiling if the equities market went into a “tailspin,” according to Kelly.
“It would be an act of extraordinary recklessness to default on the debt just because you don’t get your way in these negotiations,” Kelly said by phone, referring to the debt ceiling. “If we actually default on the debt, we’d have a massive collapse in the stock market.” Borrowing costs risk climbing and “a second great financial crisis” could be triggered, according to Kelly. He said “the damage to global markets could be huge because of how dominant the U.S. dollar is and how dominant U.S. Treasurys are in world markets.”
The U.S. has operated with a debt ceiling for more than a century.
“The federal government instituted a debt ceiling in 1917 as part of the Second Liberty Bond Act to help fund the U.S. contribution to World War I,” according to Kelly’s note. “Since then, the limit has been suspended or raised over 100 times, although this has often been accompanied by some political [theater],” he wrote.
Kelly suggested the U.S. should “get rid” of the debt ceiling to avoid its being used as a “political football” that creates worries about the Treasury itself running out of cash.
“We’d be trashing our own credit rating,” he said. “This is a stupid game they’re playing.”
Victor Reklaitis contributed to this report.