Biden's Game Of Chicken: "We Won't See A Debt Ceiling Solution Until The Market Panics"
By Philip Marey, Senior Strategist at Rabobank
Yesterday, Treasury Secretary Yellen sent a new letter to the Congressional leadership, with the message that the X-date could arrive as soon as June 1.
With the adoption of the Limit, Save, Grow Act in the House of Representatives and President Biden’s unwillingness to negotiate about conditions for a raise in the debt limit, a game of chicken between Republicans and Democrats has started.
So far, markets reacted to the possibility of a US federal government default with a revealed preference for one month treasury bills over longer dated T-bills. However, we are still far from the panic needed to break the stalemate between Republicans and Democrats. This is likely to occur closer to the X-date.
Either this game is over within a few weeks or we are going to see a suspension of the debt limit until later this year. In both cases, we are not likely to see any solution until financial markets start to panic.
Although the midterm elections in November turned out better for the Democrats than could have been expected based on the high inflation rate and President Biden’s low approval rating, they lost their majority in the House of Representatives. With the 118th Congress in session since early January, the balance of power in Washington DC has shifted. After two years of Democratic Control, with Democratic majorities in both chambers of Congress and a Democratic President, the Republicans are now able to shoot down any bill on the House floor in the next two years. This means a regime shift has taken place in US politics this year to Divided Government, where legislation requires bipartisan cooperation. The first of the fiscal standoffs that we warned for in Midterm implications is already taking shape and it is the most dangerous one, the debt limit.
On April 26, the House of Representatives adopted the Limit, Save, Grow Act of 2023, presented by House Speaker McCarthy a week earlier, with a 217-215 vote. All Democrats voted no, so did four Republicans. The bill, drafted by the leadership of the House Republicans, in consultation with various members, raises the debt limit by $1.5 trillion or until March 31, 2024, whichever comes first. Note that the current debt limit of $31.381 trillion was reached on January 19, after which the Treasury Department started extraordinary measures, postponing the X-date, when the Treasury will be unable to meet all of its debt obligations. In exchange for the higher debt ceiling, the House Republicans want to limit government spending. The bill sets discretionary spending for fiscal year 2024 (October 1, 2023 - September 30, 2024) at the level of fiscal year 2022 and then limits growth in discretionary spending to no more than 1% a year in the next decade. The bill also rescinds unspent COVID relief funds, and make changes to energy, regulatory and permitting policies. However, the plan also cuts the increased funding for the Internal Revenue Service (IRS). What’s more, it will prevent implementation of President Biden’s student debt cancellation and Income-Driven Repayment (IDR) expansion, and impose or expand work requirements in several federal safety net programs. This means serious concessions by the Democrats, which they are not likely to agree to. In fact, President Biden has made clear repeatedly that he does not want to negotiate at all. His position remains that he wants a “clean” debt limit raise, i.e. without any condition.
Biden’s game of chicken
With the adoption of Limit, Save, Grow Act by the House of Representatives, and Biden’s demand for a “clean” raise of the debt limit, a game of chicken has started between Republicans and Democrats. Both parties want to avoid a government default, which would cause significant damage to the financial markets and the economy. Consequently, the so-called X-date, when the extraordinary measures are exhausted, is the deadline for the game of chicken. In the time before the deadline, we are not likely to see any party blink, unless a financial market panic breaks out. Once the deadline passes, neither party has an interest in keeping the US in default. By this time, financial markets will definitely be in turmoil.
It could be argued, especially by Democrats, that as the Republicans are the party attaching conditions to the debt limit increase necessary to avert or end the default, they are likely to bear most of the pressure to concede. This argument frames the current game as a repeat of 2011 and 2013. However, the crucial difference is that the Limit, Save, Grow Act is actually a bill to raise the debt ceiling! So it is misleading to claim that “House Republicans are holding our economy hostage and threatening default” as the White House press secretary did on April 27. In fact, it could be argued, in particular by Republicans, that the Democrats are the obstacle to a raise in the debt ceiling. After all, if the Senate – where Democrats are needed to get the 60 necessary votes – adopts this bill and President Biden signs it into law, the debt ceiling is lifted. The truth is that after the difficult process to confirm McCarthy as the new House Speaker in January, the Democrats hoped that the House Republicans would not be able to agree on what they wanted in exchange for a raise in the debt limit. That would have strengthened the Democrats’ demand for a clean raise, i.e. without conditions. Now, it seems reasonable to start negotiations about spending cuts attached to the raise in the debt ceiling. However, a game of chicken with financial market turmoil as leverage is more likely to unfold. In the end, i.e. close to the X-date, the game of chicken is likely to be resolved under pressure from financial markets. So how are markets reacting to the developments regarding the debt ceiling so far?
Markets looking for near-term safety
On January 13, Treasury Secretary Yellen sent a letter to the Congressional leadership, noting that it was unlikely that cash and extraordinary measures would be exhausted before early June. To avoid the risk of holding a treasury bill that may not be repaid investors have shown a preference for near-term treasury bills in recent weeks. The yield on one month bills has clearly moved away from the yield on three, six or twelve month bills. While the yields on the latter three maturities continue to move together, the one month yield tanked after McCarthy’s presentation of the Republican plan brought the debt limit to the forefront. Demand from money market funds likely played a major role in the decline in the one month yield. Recently, money market funds have received large inflows from depositors concerned about the safety of their holdings at small banks or their modest returns at large banks. At the same time, the supply of near-term T-bills has fallen as the Treasury has already hit the debt ceiling and is trying to delay the X-date. So far, markets reacted to the possibility of a US federal government default with a revealed preference for one month T-bills over longer dated T-bills (This should subside as early June enters the one month horizon). However, we are still far from the panic needed to bring Democrats and Republicans together. This is likely to occur closer to the X-date
X-date in June?
On May 1, Treasury Secretary Yellen sent a new letter to the Congressional leadership, with the message that “After reviewing recent federal tax receipts, our best estimate is that we will be unable to continue to satisfy all of the government’s obligations by early June, and potentially as early as June 1, if Congress does not raise or suspend the debt limit before that time.” This means that the X-date could arrive sooner than previously expected, due to disappointing tax receipts. Shortly after Yellen’s announcement, President Biden invited top Republicans and Democrats for a meeting next week about raising the debt limit. However, a White House official said that Biden will repeat his view that Congress should pass a stand-alone increase in the debt limit, but that he is open to a discussion on the budget that is not linked to raising the debt limit. In other words, the Democrats are not blinking, neither are the Republicans.
Also on May 1, the Congressional Budget Office (CBO), a nonpartisan budget agency, updated its budget projections and concluded that lower-than-expected tax receipts this year create a significantly greater risk that the Treasury will run out of funds in early June. Earlier, they forecasted that the default could occur as soon as July. While, prior to May 1, markets had a wide range of forecasts regarding the X-date, from June to September, and even beyond, it looks like the probability of the X-date being located in June has increased substantially.
This would increase the pressure on the players of the game of chicken rapidly in the coming weeks. Alternatively, or because of this, we could see a temporary suspension of the debt limit to buy more time to negotiate (the Republicans are likely to want something in exchange for that, probably something from the Limit, Save, Grow Act they adopted last week). For example, Congress could delay the deadline to the end of the fiscal year, September 30. This would bring the deadline for the budget for fiscal year 2024 and the deadline for the debt limit together, allowing for a comprehensive solution. However, it would also add to the pressure at the new X-date, because failure to reach a deal would lead to both a government shutdown and a government default.
The game of chicken between Democrats and Republicans has really kicked off after the House of Representatives voted for the Limit, Save, Grow Act, Treasury Secretary Yellen sent a letter indicating that the X-date could arrive as soon as June 1, and Biden’s repeated dismissal of any conditions attached to a raise in the debt limit. Either this game is over within a few weeks or we are going to see a delay until later this year. In both cases, we are not likely to see any solution until financial markets start to panic.