The US debt ceiling could be the next crisis looming as Treasury secretary Janet Yellen recently warned that the US could default as early as June unless the official borrowing cap is lifted.
The debt ceiling is a legislative limit on how much debt the US Treasury is allowed to incur and exceeding this budget leads to a technical default (as it is due to administrative constraints rather than an actual default).
This issue is usually resolved by raising the debt ceiling, which the US has done 47 times since 1980.
It sometimes comes with a cost. For example, the US government lost its AAA credit rating in 2011 after raising the debt ceiling.
This process is technically repeatable, but it requires Congress to agree to raise the debt ceiling.
However, there are fears that Congress might refuse to raise the debt ceiling this time around. This is because the Republicans dominate Congress while the Democrats are in the charge of the federal government. With the US presidential election next year and a very polarised political landscape, there is a risk that both parties might not be willing to compromise.
For instance, former US president Donald Trump – who plans to run in the 2024 election – called on Republican lawmakers to let the US default unless Democrats agree to spending cuts.
For now, this issue remains political in the sense that the market seems to disregard the debt ceiling issue.
Russ Mould, investment director at AJ Bell, said: “The US stock market is doing well, the benchmark US 10-year government bond yields are barely flickering and the dollar is barely changed from a year ago, so markets appear unconcerned about the imminent US debt ceiling.
“But such confidence could be seen as complacency, because the issues behind America’s borrowing mountain are fundamental for the global economy and asset prices.”
US debt ceiling over time
Source: US Treasury, US Government Publishing Office
Should the US default, there would be consequences not only for fixed-income but also equity investors.
Jim Leaviss, primary manager of the M&G Global Macro Bond fund, said: “Some people suggest that a debt ceiling default would cause hundreds of thousands of people to be made redundant in the United States.
“A huge rise in unemployment rates would cause lower inflation, lower bond yields, flight to quality and risky assets doing badly.”
Leaviss added that if a default did happen, long-dated US Treasuries would still be regarded as safer than corporate bonds, equities and riskier assets in general.
As the US is the most important capital market, the largest economy in the world and the holder of the reserve currency of choice, the impact of a default would be global.
Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International, said: “This low-probability but high-risk worst case scenario, where no extension can be agreed, does have the potential to cause severe damage to the global economy, via severe disruptions to US Treasuries and US dollar market functioning.
“In this scenario, we would expect gold and possibly the yen to outperform.”
A more plausible scenario is the downgrade of the US sovereign debt, which could come as a result of protracted or contentious negotiations between the federal government and Congress.
A downgrade would have knock-on effects on the sovereign ceiling, which is a principle stating that the highest credit rating in a country has to be the sovereign debt. Therefore, a downgrade of the US government credit would impact other asset classes.
Ahmed said: “It is worth keeping in mind that US Treasuries serve as the benchmark rate for valuing financial and other assets around the globe.
“The significant disruption to US Treasuries and the US dollar, should the full faith and credit of the US government come into question, would be highly damaging to the global markets and economy.”
Even if the issue is resolved without any consequence on the US debt rating, volatility is still likely to increase across the bond, equities and foreign exchange markets as June draws nearer.
This is because the US Treasury is running down its Treasury General Account (TGA), which means it cannot increase the amount of Treasury bill issuance above what it receives in tax receipts until the debt ceiling is raised.
US tax receipts vs spending
Source: US Treasury
Mike Riddell, head of fixed income macro unconstrained at Allianz Global Investors, said: “Running down the TGA is a loosening of financial conditions, because new Treasury bills are not being issued to drain liquidity.
“Assuming the debt ceiling is raised, there will be renewed bond and T-bill issuance as the TGA is increased again, which reduces liquidity available to the banking system, acting as monetary tightening.”
He added that any debt ceiling increase will likely be conditional on government spending cuts, which will further reduce economic growth in the medium term.
Nonetheless, the US debt ceiling is not the number one preoccupation for Riddell.
He said: “Far more relevant to us is the unprecedented pace of global monetary policy tightening seen over the last year and the monetary contraction that we are beginning to see, where there is growing evidence that a full blown credit crunch is already underway.
“Unlike with the US debt ceiling, it seems there’s not much anyone can now do to stop the global credit crunch. A US government shutdown will just make the crunch and the fallout for the US and global economy, even worse.”
For Fidelity’s Ahmed, the US debt ceiling is not the most significant macro issue either, as he believes the debt ceiling will eventually be increased.
Ahmed said: “At the moment, the US debt ceiling negotiation is a risk factor that we are monitoring closely, but it is not among the most significant driver of portfolio positioning, as we are in the camp that a resolution will ultimately be agreed.”
However, for M&G’s Leaviss, the US debt ceiling is a growing concern.
He concluded: “There is always a lot of worries in fixed-income markets. Inflation has been the biggest thing for the past year, the war in Ukraine and trade tensions are other important worries.
“But now that the rate hiking cycles appear to be towards an end and inflation appears to be coming down, this is probably the number one thing.”