So if we are to believe Janet Yellen, Oct 18 will be the day (more or less) that the US runs out of cash! Biden is sitting this one out, waiting for the Senate to get its ducks in a row. I guess its politics.
Wait a sec, haven’t we been here before? For more recent market participants, you would be forgiven for believing the bang and bluster of the media headlines, but lets zoom out.
We have been here in 2011. In fact, here’s a link to the special FOMC meeting in that year which may give us a blue print of what the plan may be if a hard debt ceiling is adhered to now. Back then, the US earned itself a downgrade by S&P from AAA to AA+, something which hardly moved the needle but earned the ire of the Obama administration. Anyone remember that?
We then had a replay in 2013. In fact, here’s a link some commentary of mine for Bloomberg and M&G back then. Of course, the uncertainty causes waves and volatility in the near term. But in line with my comment then, the world and the US specifically can ill afford to let the debt ceiling stick and this feature alone is why the likelihood of it remaining in force is improbable.
What is the debt ceiling?
In a nutshell, Senate agrees to raise the amount of debt that the US government is allowed to take on in any given fiscal term. This is to allow it to meet its spending objectives and pay its creditors. And there are A LOT of those. $28.8 trillion and counting. Here’s a nice link to the US Debt Clock to terrify you.
In fact, the US has blown its debt limit (think of it as an overdraft) on 1 August already and is currently living off the cash under the mattress per se. These are the ‘extraordinary measures’ that Yellen refers to in the aforementioned story. So, the question is how long the cash balances last?
What happened the last time we went down this road?
So in the US, it was ugly. There were cutbacks to social spending. For example, government offices were shut. Think postal services, Medicare, or anything to do with social security. This cascaded down to cuts in certain states. Think public transport, firemen, police officers, etc.
Obviously given that each state has its own resources, the effect was felt differently based on where you were. This continued for some time until the politicians in Washington decided to reconvene (I might add there were some holidays in between) and resolved their differences.
But what was the market impact, especially in the longer term?
Social impact aside, as mentioned, S&P were bold enough to move the US down a notch in 2011. Not that it mattered. Other than being castigated, the US dollar remain the global reserve currency.
Treasury yields rose A LOT during the ‘uncertainty’ phase. Roughly from 2.5% to around 3.5%. That’s massive. But they subsequently resumed the downward march.
(If you are unfamiliar with how bonds and yields work, please check out this podcast I did called Yield Masterclass to run through the basics.)
UST’s remained the global risk free rate. ‘Take that ratings agencies’. 2013 was similarly a non-event in the longer term.
So what’s the game plan?
Well, this is the opposite of ‘this time it’s different’. In fact, perhaps its more of the same. A lot of noise and volatility which culminates in futility. If the contours of the previous plan are a framework, the Treasury would continue to pay interest on securities already issued as they come due. If any securities mature, the Treasury would pay the principal by issuing new debt for the same amount, effectively not taking on any new debt.
Payments on all other obligations would be delayed until there was cash to pay the full day’s obligations, meaning that it needn’t become a ‘pick and choose’ exercise.
What’s the cost?
Previous modelling suggests that the simple fact that the US ‘can’t’ default allows approximately 25bps premium on its bonds (a lower cost of funding). Theoretically, if this were to be removed, it would imply a rise in bond yields of around this much with some models suggesting a move of at least 21-4 bps in the near end of the curve and a further 8bps along the term structure.
The fact is, we don’t know. I recall running similar models in South Africa when ratings downgrades were looming. Each model is based on assumptions, and they provide a guide on direction and magnitude, in a vacuum. Take it with a pinch of salt.
In this piece and this one too about 2 months back, I wrote about how I though yields (then around 1.18%) were looking ‘ripe’ and favored a move to 1.5% or maybe 2% . They’re now 1.5% and while not ‘done’, they are getting close. Technically if these levels breach to the upside, we could see that move to 1.75% and maybe close on 2%. But we are now a lot further into the move.
In fairness, my recent views on inflation are up for review as I have not been right. The stickiness factors in specific commodity prices are a concern. But that’s also why I am not dogmatic. In fact, I provided for the possibility that inflation runs hotter for longer. I covered that here (Investing for inflation).
Surprisingly, the dollar remains very strong which perhaps supports my hypothesis, that while bond yields have spiked recently, that it may have more to do with inflation concerns than the debt issue. That’s why I keep the view that this is less about the debt and debt ceiling than it is about the politics and the ‘wheeling dealing’ on Capitol Hill.
Chart and image sources: TradingView, USdebtclock.org