In a note released on Monday commenting on the looming US debt ceiling showdown and the growing threat of a government shutdown and technical default by the US, Compass Point analyst Isaac Boltansky said he is becoming increasingly concerned that fall deadlines for federal government funding and the debt ceiling will prove tougher than the market currently expects, resulting in "markets roiled heading into 4Q and Fed’s policy normalization trajectory facing complications." He adds that the increasingly fragmented legislative landscape may be set to "transition from inaction to dysfunction", citing such factors as:
- Lawmakers return in Sept. with no clear strategy
- GOP leaders will likely be forced to rely on sizable contingents of Democrats
- Current spending caps for FY2018 are "despised" by both Democrats, Republicans, but for wholly different reasons
- White House’s position remains unclear as Treasury Sec. Steven Mnuchin has repeatedly called for a clean debt ceiling increase, but over the weekend President Donald Trump and OMB Director Mick Mulvaney suggested putting legislative activity on hold until health care is addressed
As a result, Boltansky sees odds of govt shutdown as materially higher than the likelihood of reaching debt ceiling as core components of spending fight (including border wall funding) are "meaningfully more politically complicated" than raising debt ceiling; his base case is for the federal government to face a brief shutdown in early October.
While that may be a little extreme, the reality is that with Congress critically fragmented, and with increasingly more politicians chosing to ignore anything that comes out of the mouth of the president, a happy ending is by no means assured and, as Boltansky suggests, "market event" may be necessary to spur Congress into action, similar to the passage of the TARP bill.
For a more nuanced look we go to SocGen's Stephen Gallagher which lays out the debt ceiling events over the next 2 motnh, as well as the 5 scenarios on how the debt ceiling drama, 2017 edition, will play out:
Debt limit divisions & decisions
The House is in recess until early September, but lawmakers will return with just 12 legislative calendar days in which to raise the debt limit or risk a technical default, . Unlike the 2011 and 2013 episodes, however, this time is indeed different, with Republicans in charge of Congress and the White House. Nevertheless, intraparty politics are still fraught with dangers. Here are some of the details of the debt limit, as well as the political dynamics involved in getting a deal done. In addition, we look at how politically-induced volatility could impact rates.
Debt limit background
As part of the negotiations that produced the Bipartisan Budget Act of 2015, which was signed into law in early November 2015, the debt limit was suspended at $18.1 trillion until March 2017. The suspension allowed the Treasury to borrow whatever it needed in the interim so that it could continue to make payments and meet its obligations. In March, the debt limit was reset higher to account for the additional amount Treasury had borrowed, at the new level of $19.8 trillion. However, the reset did not allow Treasury to exceed that limit. Treasury resorted to a tactic, known as “extraordinary measures,” that it has used in the past to continue issuing new debt to pay for existing bills. However, these extraordinary measures only provide temporary relief for the Treasury. If Congress does not either suspend the debt limit until some future date, or raise the level of the debt limit, Treasury will have far less cash on hand than needed to meet its obligations on time, an outcome that ratings agencies in the past have said would amount to a technical default.
Where we stand today on the debt limit
On Friday, Treasury Secretary Mnuchin sent a letter to Congress informing lawmakers that he currently expects that Treasury will exhaust the extraordinary measures by September 29, so Congress must address the debt limit prior to that date. Meanwhile, the CBO recently indicated that Treasury would have enough cash on hand to pay its bills until early-to-mid October. In either case, the House is currently on recess until early September. When lawmakers return, they will have 12 legislative days before September 29 in which to raise the debt limit.
In recent years, raising or suspending the debt limit has become a partisan weapon. During the Obama presidency, conservative Republicans threatened not to raise the debt limit on several occasions unless the increase was accompanied by substantial cuts in domestic spending, or unless the President agreed to scale back or repeal the Affordable Care Act. This brinksmanship led to the downgrade of the creditworthiness of US sovereign debt in 2011, played a role in the episode that resulted in the 2013 government shutdown, and was also at the center of negotiations that resulted in the Bipartisan Budget Act of 2015.
However, this time is indeed different. Republicans control both chambers of Congress and the White House. In theory, that should make it easier for them to tackle the debt limit. Instead, intraparty infighting over how to address the debt limit has already raised concerns that a resolution will come down to the very last minute, a scenario that has the potential to roil markets.
Fiscal deadlines collide
Treasury Secretary Mnuchin has indicated that the White House wants to see the debt limit increased with no strings attached. However, the so-called Freedom Caucus, a group of approximately 30-40 conservative Republicans who consistently voted against debt ceiling increases during the Obama years, have vowed to oppose an increase without deep spending cuts. Republican leaders in the House cannot afford to lose more than about two dozen votes, so if the Freedom Caucus withholds its votes, Speaker Ryan would need to pivot to get support from Democrats, who will likely demand something in return, as the GOP did during the 2011, 2013, and 2015 debt limit standoffs. As if those were not already difficult enough dynamics, further complicating matters are two other important, and related, issues, both of which will require help from Democrats in the Senate.
First, the government must pass a new budget for Fiscal Year 2018 by the end of September or risk a government shutdown that begins on October 1. Republicans remember that they were largely blamed by the public for the 2013 shutdown, so leadership will be keen to avoid a repeat, especially in light of their failure to advance a health care bill.
Second, Republicans passed four of twelve appropriations bills in the House recently. One of those bills increased outlays on the military by $70 billion. However, if spending at that level makes its way into a final bill in Congress, it would put military spending above agreed-upon spending caps that were part of the Budget Control Act of 2011 (BCA). Any change to the caps will require the aid of Democrats in the Senate, as it will need 60 votes to pass. Democrats will be unwilling to boost military spending without a corresponding rise in non-defense discretionary spending (an agreement to raise caps on both areas was actually accomplished in the Bipartisan Budget Act of 2015, but it was only for two years). Additionally, the House-passed bills include money for the border wall, something that Democrats have long opposed
What might Congress do?
The House needs to get to 218 votes on the debt limit, and the Senate will need 60 votes to find a resolution. Of course, the problem for Republicans in recent years has been that a compromise in the Senate that garnered 60 votes on fiscal issues alienated a number of conservatives in the House and required the help of a substantial number of House Democrats to pass. Indeed, when the Freedom Caucus consistently voted against prior debt limit deals, former Speaker Boehner relied on votes from Democrats to reach the magic number. Below, we provide a few scenarios for passing the debt limit and place (admittedly subjective) probabilities on them. We caution that these scenarios are by no means exhaustive. Negotiations between the two parties will likely only get underway in earnest in a few weeks, so the situation remains very fluid.
- Scenario 1: Raising the caps on both defense and non-defense spending (35%)
Under this scenario, the debt limit would be increased as part of a budget deal that raised both defense and non-defense spending by equal amounts, similar to what occurred as part of the Bipartisan Budget Act of 2015. It would almost certainly be opposed by the Freedom Caucus, but it will likely garner the support of Democrats in both chambers. Those negotiations could still be imperilled by poison pills (e.g. money for the border wall), but if the result is an increase in non-defense spending, Democrats may be willing to go along. The 2015 Act could serve as a blueprint, both parties would get the types of increased spending they desire, and most importantly, it could allow the GOP to move past these fiscal issues and focus their energy on getting tax reform passed in both chambers before the end of the year.
- Scenario 2: Kicking the can down the road (25%)
Passing a continuing resolution (CR) that extends funding for the government at current levels and also suspends/increases the debt limit for some time may be an appealing option for both parties if no resolution to the issue seems likely. However, the length of the CR is up for debate. On the one hand, Democrats may be unwilling to offer Republicans a reprieve of several months, fearing that it may give the GOP enough time in which to pass their top legislative priority and score a “win.” On the flip side, Republicans are unlikely to be held hostage to short-term increases in the debt limit. Still, a short-term CR (e.g. one month) could provide some breathing room to reach a broader deal on the budget anddebt limit that mirrors Scenario 1.
- Scenario 3: A straight increase with no strings attached (20%)
This may be the easiest approach, but it also relies on Republicans needing only eight votes from Democrats in the Senate. A no strings attached bill to increase the debt limit would be politically unpalatable to the Freedom Caucus, but it could garner the support of Democrats in the House who we suspect may not want to be seen as playing politics with the health of the economy and financial markets, something that they continually chastised Republicans for during prior debt limit negotiations. That is also true of the number of Senate Democrats at risk in the 2018 mid-terms. Additionally, it would allow Democrats to claim that they can work in a bipartisan manner, and it would also allow them to focus their firepower on the budget negotiations, where they have leverage.
All that being said, if it becomes clear that a substantial number of votes from Democrats are needed, they may unite in opposing a straight increase unless they get something in return. As Minority Leader Pelosi noted in early June, “I don’t have any intention of supporting a lifting of the debt ceiling to enable the Republicans to give another tax break to the wealthy in our country.” The margin of error for Republicans here will be key.
- Scenario 4: Attaching a debt-limit amendment to must-pass legislation (15%)
This scenario is currently being contemplated in the Senate, which will likely take the lead on the debt limit given that the Senate is in session until mid-August while the House is away until early September. Majority Leader McConnell has floated the idea of tying a debt limit increase to a must-pass bill like the Veterans Choice program. That piece of legislation was enacted in response to long wait times at Veterans hospitals, and the program may run out of funding this fall. It would create a difficult vote for Democrats in the Senate, but they could balk it given the partisan nature of the move.
- Scenario 5: A budget resolution that allows for a simple majority to raise the limit (5%)
Had the House passed a budget resolution, the Senate could have attached a debt limit increase to it and passed it with a simple majority vote. As of now, there is no budget resolution as House Republicans continue to wrangle over cuts to mandatory programs. The House is in recess now, but if they are able to agree on a budget resolution and pass one when they return in September, it could allow the Senate to pass a debt limit increase with just 50 votes (with Vice President Pence casting a tie-breaking vote). Given the divisions in the House on what exactly the budget resolution should contain, we place low odds on this scenario.
In any case, all of these scenarios are likely to become clearer over the next two weeks, as the Senate could move on scenario 3 before mid-August. If it fails, then it would increase the odds of the first two scenarios being the likely vehicle for a debt limit increase. Regardless, as has been the case in recent years, it could become a volatile time for markets.
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Debt ceiling vs Fed balance-sheet unwind – let the games begin!
All indications are that the Fed will announce a change to its reinvestment policy “relatively soon”, implying an announcement at the September meeting. The next FOMC meeting is scheduled for 20 September just ahead of the deadline for raising the debt ceiling, which we estimate will be reached in early October. Treasury Secretary Mnuchin emphasised in a speech last week that “There's also an implied cost of uncertainty into the market. And the longer we wait, that more that uncertainty will be” and urged Congress to increase the debt ceiling before the August recess. This cost is already being borne by the government as the 3m and 6m T-bills auctioned last week due to expire in early October tailed by 2bp as the 3m/6m curve inverted (see Graph 1). Primary dealer Treasury bill holdings rose sharply (see Graph 2) as investors shied away from bills maturing in October. While we believe that this inversion is owing to demand dynamics in the bill market and the curve is already on its way to normalising, it is the first warning shot for border market repercussions related to the debt ceiling deadline.
Is this time different?
Unlike prior debt ceiling episodes, what complicates the debate around raising the debt ceiling in the autumn is that these negotiations coincide with the contentious FY18 budget discussions. This meaningfully increases the odds of a government shutdown in early October akin to what we saw in October 2013.
Looking back in time, we have had three instances of a federal government shutdown since the mid-1990s. The shutdown in November 1995 came about when President Clinton vetoed the CR, causing the government to be shutdown on 13-19 November 1995. The second shutdown was shortly after, from 15 December 1995 to 6 January 1996. The third was during President Obama’s second term, from 30 September to 17 October 2013, which coincided with the debt ceiling and exacerbated the impact on the bond market. Looking at the bond market reaction to prior episodes of government shutdowns, it is not surprising that in every instance bonds rallied as investors flocked to the safety of bonds.