U.S. Economy: Renegotiating the Debt Ceiling

Last week, the U.S. Treasury hit the debt ceiling. How will markets respond as Congress decides how to move forward? Chief Cross-Asset Strategist Andrew Sheets and Head of Global Thematic and Public Policy Research Michael Zezas discuss.

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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Morgan Stanley's Chief Cross-Asset Strategist. 

Michael Zezas: And I'm Michael Zezas, Head of Global Thematic and Public Policy Research. 

Andrew Sheets: And on this special episode of the podcast, we'll be discussing the U.S. debt ceiling. It's Wednesday, January 25th at 2 p.m. in London. 

Michael Zezas: And 9 a.m. in New York. 

Andrew Sheets: Mike, it's great to be here with you. I'm sure many listeners are familiar with the U.S. debt ceiling, but it's still probably worthwhile to spend 30 seconds on what it is and what hitting the debt ceiling really means. 

Michael Zezas: Well, in short, it means the government hit its legal limit, as set by Congress, to issue Treasury bonds. And when that happens, it can't access the cash it needs to make the payments it's mandated to make by Congress through appropriations. Hitting this limit isn't about the U.S. being unable to market its bonds, it's about Congress telling Treasury it can't do that until Congress authorizes it to have more bonds outstanding. Now, we hit the debt ceiling last week, but Treasury can buy time using cash management measures to avoid running out of money. And so what investors need to pay attention to is what's called the X date. So that's when there's actually not enough cash left on hand or coming in to pay all the obligations of the government. At that point, Treasury may need to prioritize some payments over others. That X date, it's a moving target and right now the estimates are that it will occur sometime this summer. 

Andrew Sheets: So I often see the debt ceiling and government shutdowns both used as reference points by investors, but the debt ceiling and government shutdowns are actually quite different things, right?

Michael Zezas: That's right. So take a step back, the easiest way to think about it is this: Congress makes separate laws dictating how much revenue the government can collect, so taxes, how much money the government has to spend, and then how much debt it's allowed to incur. So within that dynamic, a debt ceiling problem is effectively a financing problem created by Congress. This problem eventually occurs if Congress' approve spending in excess of the tax revenue it's also approved, that makes a deficit. If, in that case, if Congress hasn't also approved a high enough level of debt to allow Treasury to meet its legal obligation to make sure Congress's approved spending gets done. And if then you also pass the X date, you're unable to fund the full operations of the government, potentially including principal and interest on Treasury bonds. But alternately a government shutdown, that's a problem if Congress doesn't authorize new spending. So if Congress says the government's authorized to spend X amount of dollars until a certain date, after that date, the government can't legally spend any more money with the exception of certain mandated items like principal and interest and entitlement programs. So in that case, the government shuts down until Congress can agree on a new spending plan.

Andrew Sheets: So, Mike, let's bring this forward to where we are today in the current setup. How would you currently summarize the view of each camp when it comes to the debt ceiling? 

Michael Zezas: Well, Republicans say they won't raise the debt ceiling unless it comes with future spending cuts to reduce the budget deficit. Democrats say they just want a clean, no strings attached hike to the debt ceiling because the debate about how much money to spend is supposed to happen when Congress passes its budget, not afterwards, using the government's creditworthiness as a bargaining chip. But these positions aren't new. What's new here are two factors that we think means investors need to take the debt ceiling risk more seriously than at any point since the original debt ceiling crisis back in 2011. The first factor is that like in 2011, the debt ceiling negotiation is happening at a time when the U.S .economy is already flirting with recession. So any debt ceiling resolution that ends with reduced government spending could, at least in the near-term, cause some market concern that GDP growth could go negative. The second factor is the political dynamic, which is trickier than at any point since 2011. So Democrats control the White House and Senate, where Republicans have a slim majority in the House. And House Speaker Kevin McCarthy, he's in a tenuous position. So per the rules he agreed to with his caucus, any one member can call for a vote of no confidence to try and remove him from the speakership. And public reports are that he promised he wouldn't allow the debt ceiling to be raised without spending cuts. So the dynamic here is that both Republicans and Democrats are motivated to bring this negotiation to the brink. And because there's no obvious compromise, they'll have to improvise their way out. 

Andrew Sheets: So this idea of bringing things to the brink Mike, is I think a really nice segue to the next thing I wanted to discuss. There is a little bit of a catch 22 here where markets currently seem relatively relaxed about this risk. But the more relaxed markets are when it comes to the debt ceiling, the less urgency there might be to act, because one of the reasons to act is this risk that a default for the world's largest borrower would be a major financial disruption. So it's almost as if things might need to get worse in order to catalyze a resolution for things to get better. 

Michael Zezas: Yeah, I think that's right. And as you recall, that's pretty much what happened in 2011. The debt ceiling was a major story in May and June with extraordinary measures set to run out in early August. But markets remained near their highs until late July on continued hope that lawmakers would work something out. And this dynamic has been repeated around subsequent debt ceiling crisis over the last 11 or 12 years, and markets have almost become conditioned to sort of ignore this dynamic until it gets really close to being a problem. 

Andrew Sheets: And that's a great point, because I do think it's worth going back to 2011, as you mentioned, you know, there you had a situation by which you needed Congress and the White House to act by early August. And then it was only then, at kind of the last moment, that things got volatile in a hurry. You know, over the course of two weeks, starting in late July of 2011, the U.S. stock market dropped 17% and U.S. bond yields fell almost 1%. 

Michael Zezas: Right. And the fact that government bond yields fell, which meant government bond prices went up as the odds of default went up, it's a bit counterintuitive, right? 

Andrew Sheets: Yes. I think one would be forgiven for thinking that's an unusual result, given that the issue in question was a potential default by the issuer of those bonds, the U.S. government. But, you know, I actually think what the market was thinking was that the near-term nonpayment risk would be relatively short lived, that maybe there would be a near-term disruption, but Congress and the government would eventually reach a conclusion, especially as market volatility increased. But that the economic impact of that would be longer lasting, would lead to weaker growth over the long term, which generally supports lower bond yields. So, you know, I think that's something that's worth keeping in mind when thinking about the debt ceiling and what it means for portfolios. The most recent major example of the debt ceiling causing disruption was equities lower, but bond prices higher. 

Michael Zezas: So, Andrew, then, given that dynamic, is there really anything investors can do right now other than watch and wait and be prepared to see how this plays out? 

Andrew Sheets: Well, I do think 2011 carries some important lessons to it. One, it does say that the debt ceiling is an important issue. It really mattered for markets. It caused really large moves lower in stocks, in large moves higher in bond prices. But it also was one where the market didn't really have that reaction until almost the last minute, almost up until a couple of weeks before that final possible deadline. So I think that suggests that this is an important issue to keep an eye on. I think it suggests that if one is trying to invest over the very short term, other issues are very likely to overwhelm it. But I also think this generally is one more reason why we're approaching 2023, relatively cautious on U.S. assets. And we generally expect Bonds to do well now. Now, the debt ceiling is not the primary reason for that, but we do think that bonds are going to benefit from an environment of continued volatility and also slower growth over the course of this year. On a narrower level, this is an event that could cause disruption depending on what the maturity of the government bond in question is. And I think we've seen in prior instances where there's been some question over delays or payment, that delay matters a lot more for a 3 month bond that is expecting to get that money back quite quickly than a 10 year or a 30 year bond that is much more of an expression of where the market thinks interest rates will be over a longer period of time. So, again, you know, I think if we look back to 2011, 2011 turned out to be quite good for long term bonds of a lot of different stripes, but it certainly could pertain to some more disruption at the very front end of the bond market if that's where you happen to be to be investing. 

Andrew Sheets: Mike, thanks for taking the time to talk. 

Michael Zezas: Andrew, thanks so much for talking. 

Andrew Sheets: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.