US debt ceiling showdown – Here we go again
US Congress appears to be on course for the most dramatic and damaging showdown over raising the debt limit since 2011. Events are likely to come to a head around Q3. The 2011 episode caused severe damage to risk assets, including the A$.
In our discussion of the implications of the US November 2022 midterm elections, we focused on the high likelihood that the Republicans’ capture of control of the House would ensure that the debt ceiling would return as a concern for markets.
So we are not at all surprised that the newly installed Republican-led House has quickly made clear that there will not be an easy passage of an increase in the debt limit.
On 13 January, Treasury Secretary Yellen wrote to House Speaker Kevin McCarthy to warn that the $31.381 trillion statutory debt limit would soon be reached, forcing Treasury to take ‘extraordinary measures’ to ensure that public debt on issue does not exceed the limit. These measures are unfortunately not so ‘extraordinary’ any more and are essentially temporary cash management measures in government retirement funds.
Very few nations have a legislated nominal value limit on the stock of public debt, and with good reason. As the US Treasury website notes: “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.”
Exactly when the US might face default on its debt is never clear, given the uncertainty over the timing of tax receipts and expenditures. But Yellen expressed confidence that the temporary measures could buy time until at least ‘early June.’
Markets can be forgiven for not losing sleep over the debt ceiling just yet. The US has never defaulted and a number of Republican officials (albeit mostly in the Senate, which remains Democrat-led) insist that they will not risk default.
But many Republican House representatives will demand a substantive quid pro quo for agreeing to raise or suspend the debt limit. Indeed there were reports that a hard line on this issue was one of the conditions agreed to by McCarthy as his own party members blocked his election as Speaker.
At a minimum, it seems likely that the House leadership allows the potential default date to draw close before proposing to raise or suspend the limit only if accompanied by cuts to non-military spending. President Biden insists that he will only sign a ‘clean’ bill raising the ceiling.
Of course, in theory, if the House Republican leadership wants to avoid default and upsetting markets, it could invite Democrats for support to pass a bipartisan debt limit increase. But this seems likely to infuriate the Republican base and many House Republicans.
As such, it appears that 2023 will see the most dramatic and potentially damaging debt limit showdown since 2011, when President Obama faced an emboldened Republican House majority. While a default was narrowly avoided, the multi-month standoff prompted S&P to cut their US credit rating from AAA to AA+ on 5 August 2011. Bloomberg economists estimate that a similar showdown in 2023 could cut US GDP growth by almost 1%.
The dramatic 2011 standoff reverberated around the world. A flight to safety sparked intervention by the Bank of Japan and Swiss National Bank to stem the surge in their currencies.
The Australian dollar was extremely high in July 2011, around $1.10, bolstered by the gap between the RBA cash rate at 4.75% versus a Fed funds rate near zero. But the turmoil generated by the US debt ceiling showdown spilled over to the Aussie, which tumbled more than 10 cents in just a few weeks.
There are many differences between conditions now and in 2011. But at the very least, it seems likely that sometime from mid-year, the US Treasury’s ability to maintain zero net debt issuance while the budget deficit runs at around -5%/GDP will be exhausted.
We assess that the least likely congressional response to this would be a low-drama agreement to raise or suspend the debt limit. Risk assets are likely to come under pressure as default looms and simply avoiding default doesn’t necessarily mean no impact to markets or the economy.
The 2011 showdown was eventually resolved with President Obama reluctantly agreeing to a fiscal arrangement that produced economically damaging spending cuts. It may be that this year the White House again has to accept fiscal contraction as the price for avoiding default. This would place downward pressure on US yields and ultimately on the US dollar, once haven demand eases.
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