After his catastrophic withdrawal from Afghanistan, will Biden follow up with a technical default of the United States?
On Friday, with some segments of the bond market starting to grow increasingly nervous about the outcome of the debt ceiling debate - whose "drop dead date" is expected to fall some time between late October and early November - we laid out the two two scenarios how this particular upcoming drama could proceed in the weeks and months ahead.
But first a reminder what repo expert Scott Skyrm said, noting that "for the past several years, Congress always reached a compromise before the possibility of a "technical default" creeped into the markets. This year, as we get closer to the "drop dead date" (which hasn't yet been determined) the markets will start pricing in distortions."
And indeed they are doing just that, with the kink in the Bill curve representing the D-Day starting to gradually shift forward, from early November as of last week...
... to mid-October today, as Wrightson ICAP now expects the so-called drop-dead date -- when the government’s cash and extraordinary measures run out - to be around Oct. 22. The kink is a result of higher yields on bills that come due around the debt ceiling D-Date as investors ask for more compensation for the added risk.
By contrast, it’s possible that as short-term yields rise, yields on longer-dated Treasuries will drop amid haven demand, JPMorgan strategists wrote on Friday: “Yields on bills may move higher and coupon yields may move lower the longer the debt limit remains unresolved,” JPMorgan's Alex Roever wrote in a note Friday.
So backing up, this is what we said were the two big challenges facing Congress if the Senate Democrats are unable to raise the debt limit as part of a spending bill, and go down the reconciliation process to pass it with only 51 votes
- First, it is unclear whether all Senate Democrats would vote for a revised budget resolution that increases the debt limit by several trillion dollars. if Democrats use the reconciliation process, Senate rules would probably allow them only to raise the debt limit by a specific dollar figure, which would lead to more politically problematic headlines, rather than suspend it for a period of time, which has become the norm over the last decade as it does not lead to a specific dollar amount at the time of passage.
- Second, the current reconciliation process to pass as much as $3.5 trillion in new spending is already underway, with House committees already in the process of considering and passing their segments of the bill in committee. Revising the budget resolution, which governs that process, could interfere with consideration of that legislation, and would likely take at least a couple of weeks, if not longer. If Democrats wait until Sep. 30 to test support for a debt limit increase as part of the spending bill, they might not have sufficient time to go through all of the procedures necessary to revise the resolution before the debt limit deadline.
And while the Treasury Department continues to play it cool, saying it has no plan to sort through which payments it would prioritize in case of a default, and which U.S. government obligations it would set aside once it exhausts measures to avoid breaching the federal debt limit, Wall Street disagrees. More from Bloomberg:
The Treasury isn’t engaging in discussion of what would happen if Congress fails to suspend or increase the debt limit, which kicked in at $28.4 trillion at the beginning of August following a two-year suspension. Yellen said earlier this week that extraordinary measures to avoid breaching the limit will only last until sometime in October.
The U.S. “pays all its bills on time,” Treasury spokeswoman Lily Adams said Wednesday. “The only way for the government to address the debt ceiling is for Congress to raise or suspend the limit, just as they’ve done dozens of times before.”
However, in a worst-case scenario when the Drop-Dead Date arrives without a deal on the table, the options of prioritizing payments on publicly held U.S. Treasuries, or delaying some debt-payment dates, are still technically on the table, Wall Street strategists are telling their clients. Bolstering this view, during a 2017 round of problems over the debt limit, Moody’s said it expected the Treasury to turn to prioritizing debt servicing over other obligations if needed.
Confidence that debt payments would be prioritized also stems in part from a once-secret debt-limit contingency plan from the Obama administration that Secretary Janet Yellen’s team is at this point saying it won’t tap according to Bloomberg. Details were discussed by Federal Reserve officials during highly contentious battles over raising the debt ceiling in 2011 and 2013, as shown in transcripts of Fed conference calls.
“What the transcripts tell me is that the Treasury is able to prioritize payments,” said BofA head of interest rate strategy Mark Cabana, however their willingness to do so “is a separate question. Even if you just acknowledged the possibility, it would be very politically unpopular to say you are going to essentially pay China and Japan over paying Social Security recipients." Cabana also projected the Drop-Dead Date could happen by early November, but he’s assuming Congress lifts it or suspends it again before that.
The problem in a nutshell, is that while everyone expects some miraculous debt ceiling deal will occur just before the deadline, this may not happen.
In a worst case scenario, even if payments were sustained on Treasuries, defaulting on some of the myriad of other government obligations, from Social Security to paying for regular federal government operations, could badly damage perceptions of U.S. sovereign credit quality. Back in 2011, S&P downgraded the U.S. after a protracted if ultimately successful battle to lift the debt limit. Amid another such struggle two years later, Fitch Ratings put the U.S. on negative watch. Fitch went on to remove the designation in 2014, before putting it back on in July 2020.
Mark Zandi, chief economist at Moody’s, said that if that did come to pass, it would raise U.S. borrowing costs nevertheless given the damage of failing to make good on other obligations, even if just for a limited period.
“There’s a not-inconsequential risk in this go-around that there’s a mistake here -- and a default,” Zandi said in a phone interview Thursday. “I’m sure Treasury is looking at all kinds of break-glass scenarios” such as prioritization, he said. “But this is break-glass stuff, which means we’d be in a crisis and it would be cataclysmic and we’d be going off the rails.”
Putting it all together, this morning Goldman's economists have published another note on the upcoming debt ceiling showdown, explaining why contrary to generally cheerful sentiment that the problem will resolve itself. Here are the highlights:
We estimate Congress will need to raise the debt limit by mid-October, though it is possible the Treasury might be able to operate under the current limit until late October. It is possible, though not likely, that the Treasury might be able to continue to make all scheduled payments until sometime in early November if the deficit is smaller than expected.
There are two procedural routes congressional Democratic leaders can take to raise the debt limit, but neither is easy. Democrats would not need Republican support if they use the reconciliation process, but they would face a number of other procedural and political disadvantages. Attaching a debt limit suspension to upcoming spending legislation looks more likely, but this might not succeed and could lead to a government shutdown.
A failure to raise the debt limit would have serious negative consequences. While it seems likely that the Treasury would continue to redeem maturing Treasury securities and make coupon payments, if Congress does not raise the debt limit by the deadline the Treasury would need to halt more than 40% of expected payments, including some payments to households.
Beyond the direct impact, the debt limit could also affect the medium-term outlook for fiscal policy. We already expect the Democratic fiscal package to be scaled back from the proposed $3.5 trillion/10 years in new spending to $2.5 trillion, offset by around $1.5 trillion in new tax revenue. While there is not necessarily a direct linkage between the debt limit and the fiscal package, the more these issues become entangled the more pressure there may be from centrist Democrats to scale back the size of the fiscal package.
Stepping back for a second, we remind readers that calculations for the Treasury "drop dead date" are fluid and depend on tax revenues as well as outlays. While consensus expects the debt limit to be hit by mid-October, Goldman calculates that the Treasury may be able to operate under the current debt limit until the end of October. If revenues surprise to the upside - the September 15 corporate tax deadline should provide new information - or outlays surprise to the downside, it is possible, though not likely, that the Treasury might be able to continue to make all scheduled payments until sometime in early November.
In addition to complications arising from unpredictable cash flows, this time around there is also the Treasury’s higher-than-usual cash balance which adds further ambiguity. In the past, the Treasury’s projection of the date by which Congress needs to raise the debt limit has assumed a minimum level that the cash balance must not drop below (e.g. $25bn). Since the cash balance is usually much smaller than it has been over the last year, the main determinant of the deadline was the size of the deficit relative to the “extraordinary measures” that Treasury can employ to make room for additional borrowing under the limit.
This time around, the Treasury started with a cash balance of $459BN when the debt limit was reinstated Aug. 2, much larger than ahead of prior debt limit deadlines. This has declined to around $200BN as of Friday. In this context, Goldman notes that in light of greater uncertainty regarding cash flows, "setting a higher minimum cash balance than usual would be prudent. That said, a projection that the debt limit must be raised at the same time that the Treasury has a large cash balance would likely reduce the credibility of the projection and the urgency Congress feels at that point to raise it." The deadline is likely to fall in October regardless, we believe, but a more conservative (higher) assumption regarding the cash balance could put the deadline earlier in the month, while a lower assumption would put the deadline closer to the end of the month.
While the drop-dead date remains fluid, where we have some more certainly is what the way ahead would look like.
As we explained last week, there are two procedural routes congressional Democratic leaders can take to raise the debt limit, but as Goldman again warns, neither is easy - here's why as the bank's chief economist Jan Hatzius explains:
- The first would be to pass the increase via the reconciliation process, which they are also attempting to use to pass a broad fiscal package. The only advantage this would provide is that reconciliation legislation requires only 51 votes to pass the Senate, rather than the 60 usually needed. In theory, it could pass with only Democratic votes. However, using the reconciliation process has several disadvantages. First, it would require Democrats to pass a new budget resolution. The resolution the House and Senate passed in August House and Senate passed last month to provide procedural protections to their $3.5 trillion fiscal legislation omitted a debt limit increase. Revising the resolution would take time and there is some question as to whether it would be procedurally possible. Since the resolution also sets the parameters for the upcoming fiscal package that has already started to move through committees, reopening the budget resolution could create problems for that bill as some centrist Democrats might be loath to vote again to allow such a large package, particularly if a debt limit increase is attached.
- Second, while Senate rules clearly allow the debt limit to be raised, there is a good chance that suspending the debt limit would be prohibited. Over the last decade, debt limit suspensions have become common instead of increases, as suspensions allow lawmakers to avoid voting on a large dollar figure. An increase lasting past the 2022 midterm elections would be in the trillions, which congressional Democrats are apt to want to avoid, particularly at the same time they are debating a large fiscal package.
- Third, using the reconciliation process would likely mean that Democrats alone would bear the political burden of raising the limit, since Republicans would be unlikely to vote for an increase (or suspension) unless absolutely necessary.
In light of these disadvantages, Goldman does not expect Democrats to pursue a reconciliation strategy for the debt limit before the end of September. Instead, it appears more likely to us that a debt limit suspension will be added to other legislation Congress will vote on in the next few weeks.
According to the bank, the most likely scenario would be for Democratic leaders to combine the debt limit suspension with a stopgap spending bill (a “continuing resolution”) that would extend spending authority past the end of the fiscal year (e.g. from Oct. 1 to mid-December) as well as provide funding for disaster relief and resettling Afghan refugees. At the moment, the vote on that bill looks likely the week of Sep. 20, though this could slip.
So what happens if Democratic leaders move forward with plans to combine the debt limit with the spending bill? Well, according to Goldman, A government shutdown becomes a very real possibility. The bank envisions three outcomes:
- The bill passes, resolving both issues. The simplest outcome would be for Republicans to allow the continuing resolution/debt limit bill to pass. This could technically happen without Republican support, if they voted against the bill but did not filibuster it—in that case, it could pass with 51 votes. That, however, won't happen. The debt limit increase might also be structured to allow the President to raise or suspend the debt limit, subject to a resolution of disapproval that would block it. Congress could pass such a resolution, but the President could veto it, leaving the debt limit increase intact. Congress used a version of this in 2011 to end the debt limit standoff that year. While such a scenario is possible again this year, Goldman points out the obvious stating that "it does not look like the most likely outcome, in our view."
- Republicans oppose the package, and Democratic leaders extend spending authority without the debt limit. As noted above, the exact date on which the Treasury will no longer be able to satisfy all its obligations is unclear, but it is probably not October 1. If Republicans are willing to support an extension of spending authority but not a debt limit increase, Democratic leaders could have a difficult time keeping the two issues joined if the debt limit is not seen as immediately pressing. Instead, a short-term extension of spending authority could push the issue until later in the month.
- Republicans oppose the package but Democrats keep them tied together. In this scenario, a shutdown would become likely. This would be more likely if the debt limit deadline turns out to be earlier in October than expected.
While Goldman believes that at this point, the combined probability of the first two options, in which the government stays open, is greater than a shutdown starting October 1, there is a good chance that the solution at the end of this month is a temporary one, and that uncertainty persists into October. Exhibit 3 summarizes the key events on the calendar through year-end.
The bottom line, as Goldman concludes, is that this is starting to look like the "Riskiest Debt Limit Deadline in a Decade." Here's why:
The upcoming debt limit deadline is beginning to look as risky as the 2011 debt limit showdown that led to Standard & Poor’s downgrade of the US sovereign rating and eventually to budget sequestration, or the 2013 deadline that overlapped with a government shutdown. Like in 2011, sizeable budget deficits have motivated Republicans to use the debt limit to win policy concessions. Like in 2013, the deadline falls soon after the end of the fiscal year, raising the prospect of a government shutdown on top of debt limit uncertainty.
To be sure, there are also differences, the main of which is that Congress is not under divided control as it was in those instances. In theory, this could have made an increase easier, since Democrats could pass it via reconciliation. Even without that process, Democrats set the agenda on the House and Senate floors and can force repeated votes on the issue, which should make it somewhat easier to pass a debt limit increase than in a divided Congress.
However, unified Democratic control has made it harder in other ways. Prior debt limit increases have usually been bipartisan because there was no other choice. This time, Democrats could theoretically increase the debt limit without Republican support, and Republicans might believe they eventually will. Republicans might eventually support an increase if there is truly no other option, so Democrats might try to eliminate any other options.
In short, we are facing down an epic game of chicken between the two political parties.
The 2011 and 2013 debt limit experiences had clear effects on financial markets and public sentiment. Exhibit 4 shows selected indicators by proximity to the deadline in those years. In 2011, the S&P downgrade and, more importantly, the economic deterioration in Europe had an impact even after the debt limit was raised. In 2013, the effects were strongest in farther ahead of the deadline, as the government shutdown preceded the deadline by more than 2 weeks.
While most expect one (or both) parties to blink in the 11th hour, what if that does not happen?
Well, if neither party blinks, it is conceivable that the Treasury could exhaust its cash balance and extraordinary measures before Congress addresses the debt limit. If this occurs, it seems reasonably clear that the Treasury could continue to make payments of principal and interest on Treasury securities - as discussed above - at least as a technical matter.
Redeeming maturing securities should not be constrained by the debt limit, since new issues would replace maturing securities without increasing the overall amount of debt subject to limit. The only obvious scenario in which redeeming maturing securities could become a problem would be if debt limit issues reduced demand for Treasuries to the extent there was insufficient demand at auctions, but this seems quite unlikely. In the period ahead of the 2013 debt limit deadline, which coincided with a government shutdown, Treasury bill auctions saw a notable decline in demand for securities compared with surrounding auctions, and a higher resulting yield, but the volume of bids was nevertheless multiples of the amount the Treasury was offering (Exhibit 5).
Meanwhile, covering interest payments without a debt limit increase would depend on the Treasury’s ability and willingness to prioritize certain payments over others. The historical record suggests this is what would indeed occur:
- In 1957, prioritization appears to have occurred following expiration of a temporary increase in the debt limit. As the federal government began to run a budget deficit following expiration, the Treasury was forced to delay payments to federal contractors.
- In 1985, ahead of the debt limit increase that year, the General Accounting Office (GAO, now known as the Government Accountability Office) advised the Senate Finance Committee that the Treasury had the authority to choose the order in which to pay obligations.
- In early 1996, the Treasury indicated that failure to raise the debt limit would result in failure to make Social Security payments, though Congress provided relief before any delay occurred.
- In July 2011, the Treasury and Fed developed procedures to prioritize government payments in the event the debt limit was not increased in time. According to an FOMC transcript from that time, principal and interest on Treasury securities would continue to be made on time and other payments could have been delayed. Principal would have been paid by rolling maturing issues into new securities. To ensure the timely payment of interest, the Treasury would have held back other payments in order to accumulate sufficient cash balances to ensure sufficient cash on hand.
- In 2013, FOMC transcripts described a similar procedure to prioritize payments on Treasury securities.
Going back to the topic of forecasting daily cash inflows and outflows, the next chart from Goldman shows estimated daily levels of federal receipts and payments, (excluding public debt transactions). The Treasury makes coupon payments infrequently and generally takes in more cash than the amount of the payment on the days they are due. If the debt limit has not been raised by the time that payment approaches, the Treasury would likely need to delay other payments, even if there is sufficient cash to make them, in order to build cash to make the coupon payment.
Of course, even if the Treasury could make its scheduled coupon payments, the consequences of a failure to raise the debt limit would be severe. As shown above, Federal outlays are likely to exceed receipts by around $500bn (2.2% of annual GDP) in total over October and November. If Congress fails to raise the limit, the Treasury would need to reduce outlays by that amount, a reduction of more than 40%. Absent an immediate resolution, the US - already addicted to trillions in government transfer payments - would quickly spiral into a consumer-led depression.
As noted above, FOMC transcripts from around the time of the 2011 and 2013 debt limit debates included a discussion of the measures the Fed might take in the event that Congress failed to raise the debt limit. While many of the actions are already part of the Fed’s toolkit, including repo and reverse repo operations, the distinguishing feature is that the Fed would maintain eligibility for Treasuries with delayed payments as collateral. Also discussed in those transcripts are CUSIP swaps, in which the Fed would swap unaffected Treasury securities on its balance sheet with delayed-payment securities. However, this was seen as a more controversial step that Chairman Powell, then a Fed governor, described as “loathsome” though one that he would not rule out “in extremis”.
Putting it all together, and the Impact of Fiscal Policy Beyond the Near-Term
Beyond the immediate (and potentially catastrophic) effects of a failure to raise the debt limit, a prolonged standoff could have more important effects on fiscal policy over the medium-term. As noted above, the debt limit needs to be raised around the same time that Congress is likely to consider major fiscal legislation to implement large parts of Biden’s agenda. To win the necessary support, Goldman expects that congressional Democratic leaders will scale down their proposed $3.5 trillion/10 years reconciliation bill to something more like $2.5 trillion in new spending financed by around $1.5 trillion in new tax revenue. Some centrist Democrats are calling for even lower figures. While there is not necessarily a direct linkage between the debt limit and the fiscal package, the more these issues become entangled the more pressure there may be from centrist Democrats to scale back the size of the fiscal package.
This is a potentially huge problem because as we discussed on Friday, the US is facing the start of a "phase 1" stagflation where only another record stimulus package allowing the US to kick the can...
... will avoid a major slowdown in 2022. Anything less, and the US economy faces a very grim fate in 2022 when the massive fiscal boosts from 2020 and 2021 become howling tailwinds, with the economy threatening to come unglued just in time for the midterm elections.