Considerable attention is currently on the US reaching its constitutional limits on the amount of debt it can accumulate, a legislative limit commonly referred to as the debt ceiling. The US reaching its debt ceiling is not a new phenomenon, and in past times did not spark a great deal of concern. Congress can choose to lift the debt ceiling, temporarily suspend it, or allow Treasury to go above the debt limit for a certain period of time. Since 1960, Congress has raised, temporarily extended or revised the debt limit 78 times. Suspending the ceiling was not common in the first 90 years after the debt ceiling was introduced. However, this has started to change, as Congress has suspended the debt limit seven times since 2013 amid prolonged political stand-offs. As can be seen from the chart below, the debt ceiling goes to zero during times when it has been suspended.
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The impact from these political clashes spills over into the real economy. In recent times there have been a growing number of instances where debate around the growing US national debt and increasing the debt ceiling has distorted financial markets and the economy. In 2011, S&P downgraded US national debt from the highest rating of AAA to AA+ due to a long debate regarding the debt ceiling. In October 2013, and again in the winter of 2018, the US government experienced shutdowns, due to neither legislation regarding funds for the next fiscal year nor a resolution bill for the past year having been passed. Among other ill-effects, this led to the furlough of thousands of federal employees and was a cause of market volatility.
As such, the annual debt ceiling debate has become a source of sovereign risk for the US. This type of risk is generally more common in emerging markets, but developed countries have experienced them too, e.g., during the European debt crisis and the UK pension fund troubles following the Truss government budget.
This year’s political debate over the debt ceiling is already shaping up to be long and difficult. The US has hit the current debt ceiling of US$31.4 trillion, or about 120% of US annual GDP. The bill to raise the debt ceiling was passed by the Republican-controlled House of Representatives on 26 April 2023, but now includes spending cuts and goes back on parts of President Biden’s domestic agenda. Mr Biden has said he would veto the bill, and the US economy still faces uncertainties as negotiations continue in the Senate, which has narrow Democratic control.
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According to US Treasury Secretary Janet Yellen, without raising the debt ceiling, the government would only be able to pay its liabilities until June, at which point it would reach the limit on its cash and spending capacity – often referred to as the ‘X Date’. However, burn rates on cash in the Treasury General Account are high, and the balance is heading towards zero at a quick pace, making even the June deadline seem uncertain. If recession hits, there would be almost no cash left for other measures, and markets are right to get worried.
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Investors’ worries have been reflected in credit default swaps (CDS) spreads. The US 1-year CDS spread has spiked to its highest level ever, surpassing the previous debt-ceiling-related high as investors are clearly worried about the prospect of a prolonged and severe lockdown.
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To put a probability behind the CDS numbers, the market has priced an almost 10-fold increase in the probability that the US may default over the next six months from 0.08% at the beginning of the year to 0.8% as of 24/04. Over a 5-year horizon, the probability has increased from 1.3% to 2.5%. Although these numbers may seem small, they affect the short-term cost of funding of banks and corporates.
Furthermore, greater uncertainty around the length of time that would be required to pass the bill which would raise the debt ceiling has been reflected in the pricing of short-term government bonds. The yield on 1-month government bonds decreased on Wednesday from just over 4% to 3.7%. The yields on 3-month government bonds are increasing. This could be a sign that investors are adding a risk premium in case the US defaults on its debt in the short run – the 1-month government bond yield could be decreasing because it matures before June, when the government could run out of cash, whereas the 3-month government bond yield increased as it is more exposed to the period where cash flows will be most stretched.
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A final reflection of markets pricing in higher risk can be seen in the MOVE bond volatility index. The MOVE index started increasing again in April after peaking in mid-March. It is likely that this renewed upward trend has been prompted by investors in bond markets pricing greater risk associated with the debt ceiling stalemate.
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Increased levels of sovereign risk due to uncertainty around the US reaching its debt ceiling can cause rates to spike. But a spike in interest rates caused by resurgent sovereign risk constrains a government in its choice of methods to deploy in tackling and cushioning a recession. Examples of levers that become difficult to pull in such a situation are fiscal stimulus, bailouts and cutting rates.
The timing and magnitude of the next US recession could thus be made worse than expected by a drawn out stand-off over the debt ceiling. Markets are showing some signs of becoming more worried over the past few days, but the current level of concern will pale into insignificance if a recession comes to pass and US policymakers’ hands remain tied by a government lockdown.
The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.
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