Angst over a possible default by the U.S. government has increased since Treasury Secretary Janet Yellen informed Congress on May 1 that cash and extraordinary measures to cover its debt obligations could be exhausted by early June. The so-called “X-date” is earlier than anticipated because revenues from income tax payments in April were about one-third lower than last year’s.
Meanwhile, President Biden has warned about the consequences for the world if there is a default. They include a likely recession, stock market sell-off and hit to the U.S. dollar. He contends it would be irresponsible for Congress not to enact a clean bill to expand the debt ceiling since it already has authorized spending for fiscal 2023.
Many economists concur that it would be a mistake for Congress to pare back discretionary spending to 2022 levels, as called for in the House Republican proposal passed on April 26. In testimony before the Senate Budget Committee, Mark Zandi of Moody’s Analytics claimed that if it were enacted, annual real GDP growth over the next 10 years would be 1.6 percent compared with 2.2 percent with a clean debt limit scenario. In that event, nondefense discretionary outlays as a percent of GDP would be cut in half from 4 percent to 2 percent.
Despite these warnings, U.S. financial markets have not reacted thus far. Both the stock market and bond market have fluctuated in trading ranges as investors are focusing on the likelihood that the Federal Reserve will pause in tightening policy. Another reason is that most investors believe the debt negotiations will go down to the wire before a deal is struck, as has typically been the case.
In reviewing the past five debt negotiations, a study by Goldman Sachs finds the one in 2011 is the most analogous to the current situation. The Obama administration was forced to negotiate with a Republican-controlled House then amid a significant fiscal expansion after the 2008-09 global financial crisis and a backdrop of recession fears. During that showdown, the S&P 500 fell by 17 percent while Standard & Poor’s downgraded the U.S. sovereign debt rating from AAA to AA+. However, the stock market subsequently rallied and Treasury yields declined after a deal was struck.
So, how are markets viewing the current situation?
One can get a rough gauge of the credit risk that is priced into the Treasury market by looking at the price for credit default swaps (CDS). These instruments are a vehicle for investors to buy protection in case the U.S. government fails to pay its debt on time. CDS spreads on one-year Treasury securities are now about 175 basis points, which means it costs $175 to insure $10,000 of Treasury securities against a default. This spread has doubled since Yellen’s announcement and the implied default rate has increased to 4 percent.
The bottom line is that financial markets are not pricing in the draconian outcome the Biden administration is warning about. However, the outcome could be on par with 2011 if the “X-date” is breached and there is not a quick resolution. This possibility has increased because House Speaker Kevin McCarthy (R-Calif.) has garnered enough Republican support to block a clean bill. Also, Donald Trump has recently urged Republican lawmakers to allow a default if Democrats do not accept massive spending cuts.
While President Biden was reluctant to negotiate over the debt ceiling initially, he met with McCarthy to discuss possible spending cuts last week. According to CNN, President Biden has responded by citing legislation that would be off the table. The list of non-starter items includes Biden’s most recent legislative accomplishment, the Inflation Reduction Act, and student debt forgiveness, which was a key campaign promise in the 2020 presidential election.
White House sources reportedly are willing to entertain a cap on future spending but for a shorter period than the 10-year cuts that were agreed to as part of the 2011 debt deliberations. The administration also seeks a debt increase of more than one year to avoid a repeat in 2024.
While it is too early to tell what the final outcome will be, both parties need to demonstrate to their bases that they have achieved their objectives. For Biden, this would mean he is able to preserve his major legislative accomplishments, while for McCarthy, it would mean he is able to extract concessions on future government spending.
Whatever the outcome, one thing is clear: U.S. fiscal policy will be hamstrung if a recession unfolds. Therefore, investors should not expect a V-shaped rebound as occurred after the COVID-19 pandemic struck in early 2020.
In the end, the most sensible approach would be to extend the negotiations on the debt ceiling to coincide with the passage of the federal budget for fiscal 2024. In this way, there would finally be consistency between the spending that Congress authorizes for the coming fiscal year and what it is prepared to pay. It would also provide a better means to put the growth of federal debt on a more sustainable path.
Nicholas Sargen, Ph.D., is an economic advisor for Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books including, “Investing in the Trump Era: How Economic Policies Impact Financial Markets.”