Insights Into Wall Street's Anti-Debt Ceiling Fears

Investors just assume that a deal will be reached when the government defaults on its debt because the consequences are so horrific.

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It is widely believed that the US will avoid a devastating federal payments default at the end of the year. However, conventional wisdom proved to be spectacularly wrong months ahead of the shocks that upended the world in recent years, such as the failure of Lehman Brothers, the US election of 2016, and the spread of Covid-19 around the globe.

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Among the reasons for this potential shock is a procedural quirk of the US government that coincides with a soaring level of political hostility between the two parties. Republicans in the House of Representatives are clamoring for concessions from the White House and Democrats before they raise the federal debt ceiling because it has reached a legal limit imposed by Congress. Standoffs such as these aren't new in the world of politics. Despite the fact that lawmakers have never been unable to pass legislation to increase or suspend the debt ceiling before the Department of the Treasury ran out of cash to make good on US obligations, the debt ceiling has never been reached.

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“When something hasn't happened for a long time, most people simply forget about it,” says Tyler Cowen, an economist at George Mason University. Thomas Schelling, the pioneer of game theory, trained him in the study of how people compete for an advantage or decide to cooperate in order to gain a competitive advantage.

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Despite a lack of optimism in the financial markets, economists are shrugging off the possibility that lawmakers might not be able to come to a deal. There is a wide assumption among the general public that, in this game, the consequences of not raising the ceiling are ultimately intolerable to both sides. It is only a matter of months before the so-called X date-the day when the government will not be able to pay all its bills comes into effect. This time around, as with previous negotiations, the politics driving the negotiations are likely to be more perilous than in the past.

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There are many Americans already experiencing high-interest rates, so a US payments default would significantly increase the cost of borrowing for everything from mortgages to credit card debt to auto loans. 401(k) portfolios that have already been battered down are now at risk of further damage. Despite a compromise that averted the S&P 500 from going into default, the 2011 partisan showdown over the debt ceiling sent the S&P 500 down 17% on the day. There is no doubt that this year's fight will be at least as contentious as last year's. Tracy Chen, portfolio manager at Brandywine Global Investment Management in Philadelphia, says that the market is quite complacent at the moment. “There is a need for investors to be very cautious, because "this year, with regard to the debt limit, it will be an extraordinary, acrimonious, and highly charged event to be sure," she says.

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Congress has already committed to spending a certain amount of money, so the debt ceiling restricts the government's borrowing ability. Despite hitting the limit in January, the Treasury has been able to continue paying so far using special accounting moves.

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It is believed that a default on federal payments would pose the biggest shock to the US financial system since the bankruptcy of Lehman Brothers caused the worst economic slump since the Great Depression. Traders and regulators have learned some lessons from the 2011 debt ceiling fight, which ended just days from a default-but nobody really knows whether the procedures in place will be sufficient to avoid another systemic financial meltdown in the future.

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As soon as the Treasury reaches the X date, its first decision would be whether it would prioritize some obligations over others, even though some experts warn that it is not possible to cherry-pick some payments over others. It is assumed that the Treasury will continue making payments on the $24 trillion of publicly held government securities that are held by the public. Defaulting on such bonds would undermine the bonds whose yields are used around the world as a benchmark for the cost of borrowing around the world as a result of default. Treasury bonds are also used as collateral for trillions of dollars worth of short-term money market loans that are issued on a daily basis. Due to the fact that they are so ingrained in the basic electrical system of the global economy, it is impossible to estimate the damage that would occur if payments were missed.

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The Securities Industry and Financial Markets Association, the top US association for broker-dealers, investment banks, and asset managers, says, "We do tabletop exercises, but we have never actually tested them." Toomey is the managing director of the organization. “The issue of what the impact of the proposal would be on the market is very much an open question when it comes to determining how these securities will trade in the trading environment and what it will mean for pricing, etc., in the trading environment”. “What are the consequences of these actions? Unknown.” Toomey says that SIFMA is not interested in observing this experiment in real life. According to him, "our opening premise is that the full faith and credit of the US government should not be compromised." "The debt limit should be raised, period."

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The government would face a political challenge if it prioritized Treasury bonds because it would have to make good on its payments to wealthy investors and other countries such as China while delaying payments for millions of federal employees, contractors, military personnel, Social Security beneficiaries, and others indefinitely. This could also affect how investors perceive the creditworthiness of the United States, undermining the value of Treasury securities and raising issues similar to the possibility of a government bond default outright.

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What if a Treasury payment was delayed? Treasury Day is rolled over each evening by one day if the Treasury does not have sufficient funds to pay off a security's maturity date. The Treasury has developed contingency procedures over the years to fulfill that requirement. This would delay the payment of the principal. It's still unclear whether all systems could process a transaction on Aug. 10 for security that should have matured and been paid off on Aug. 9.

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On the other hand, Federal Reserve Chairman Jerome Powell issued a warning in February that "no one should assume that the Fed can protect the economy from the consequences of failing to act on the debt ceiling in a timely manner" by not extending the deadline. In a Senate hearing on Tuesday, he said if Congress does not take action to resolve the issue by the end of this year, it could have "extraordinarily adverse" consequences, causing "long-lasting harm." So the "only way out" is for Congress to increase the debt ceiling, he said.

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It was one of the dangers that Powell highlighted a decade ago, when he was a member of the Federal Reserve board at the time of a showdown over the debt ceiling in Washington, that investors would be frightened into shying away from buying all of the US government debt that was offered at a Treasury auction. According to a transcript of a Fed meeting of policymakers at the time, Powell said at the time, "The real risk is the loss of market access at any price after a failed auction."

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If the Treasury were to fail to raise enough cash through the auction, it would not be able to pay off maturing debt, which would lead to a cascade of problems. During the 2011 showdown between the New York Fed and the Federal Reserve System, William Dudley, then the President of the New York Fed, explained that, if that happened, it would "certainly ratchet up the odds of a default" and would have a significant effect on the financial conditions in the capital markets.

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It will be up to Washington politicians to decide whether this is the way the story ends this year. Goldman Sachs Group Inc. has estimated that the X date is likely to come in early to mid-August, so there is still time to act. Washington, however, is finding it more and more difficult to get things done because of the complexities of legislative procedures as well as the narrow margins of partisan control in the House and Senate.

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In the same way, as in previous debt limit showdowns, Republicans are insisting on spending cuts in exchange for lifting the ceiling for a Democratic president in the coming weeks. This time, however, tensions are intensifying because Republican House Speaker Kevin McCarthy is on the verge of losing his grip on a group of conservatives who say they are determined to not compromise. By threatening not to raise the $31.4 trillion ceiling on the debt, President Biden and Democratic members of Congress have the incentive to portray Republicans as extreme and destabilizing, and this will provide them with an advantage.

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It illustrates the volatile state of politics that McCarthy narrowly missed winning the speakership 14 times before ultimately winning on the 15th vote in January. McCarthy conceded in the process by allowing a single lawmaker to force a snap vote to remove him from office. McCarthy's speakership will be imperiled, giving a small group of hardliners leverage to change legislation - like the debt ceiling bill. In the absence of such a threat, McCarthy can only count on four Republican votes against him on any party-line vote.

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Conservatives see the debt ceiling debate as a chance to paint Democrats as wasteful, inflation-inducing government spenders. A Gallup poll released in February found that only 3% of Americans viewed the federal deficit or debt as the nation's most pressing problem, down from 17% in 2011. Representative Scott Perry, chair of the conservative Freedom Caucus, says the event is an opportunity to raise awareness. “In order not to keep bankrupting the country, you must use the moment to make changes."

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Perry's allies are clearly gleeful about the prospect of reducing the size of government and there is a palpable sense of excitement in the air. He was beaming with delight as he left the House floor recently, showing off a suit-pocket debt clock that he made out of copper roofing materials. Massie, a Republican from Kentucky and a hardline conservative, was beaming as he left the House floor. “There are already more than 20 members of Congress who have requested me to make one for them," he said.

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The vice president is clinging tightly to the lessons learned from the 2011 debt standoff at the White House. In the eyes of many Democrats, the final deal ended up undermining the nation's recovery from the global financial crisis, which may cause them to be less willing to negotiate deficits this time around. As Democrats are attempting to paint the GOP as erratic, extremist, and in a relationship with former President Trump, the idea that Republicans are willing to engage in a game of chicken over the nation's creditworthiness reinforces their efforts to portray the GOP as erratic, extremist and aligned with him. “It's like they're playing Russian roulette with the economy," says John Anzalone, who conducts polls on behalf of the Biden campaign. “The American people are going to punish them for what they have done."

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The potential for a "clean" debt limit increase, which has been dubbed "one without any conditions," is one of several legislative solutions apart from a grand fiscal deal between Biden and Republicans, which now appears unlikely, including a number of moderate Republicans working with the House minority to push through a "clean" debt limit increase. However, the process is so complex that it may not be possible to accomplish as it requires so much time. Likewise, the Senate has faced challenges as well, with 24 Republican senators warning Biden that to increase the debt limit, "structural" changes will need to be made to the fiscal system.

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A down-to-the-wire political solution may still involve some major strains even if it happens at the last minute. There is a risk of something going wrong even if you have more runway than you think, as Dudley mentioned in the Federal Reserve's discussion of 2013 discussion.

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If a default on Treasuries were to occur in the worst-case scenario, it would take years for the burden to be lifted from the US economy, according to Jack Malvey, who has been following the bond market since the 1970s and is currently a special counsel at the Center for Financial Stability.

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Taking millions of federal employees and entitlement beneficiaries off the payroll would almost certainly trigger an instant recession, even if Treasury securities were fully protected. The recent wargame conducted by Barclays Plc analysts showed that if the government is going to borrow the same amount of money as it did in August 2021, the Treasury would have to cut some $200 billion in spending in August. There could be a steep decline in the gross domestic product by as much as 15% at an annualized rate if it takes weeks for the government to resume spending and make up for the delayed payments, the bank's team, led by Ajay Rajadhyaksha, wrote in a note to clients that it could be weeks before the government could resume spending and make up for those delayed payments.

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Congress might be forced to act by market turmoil. In the financial crisis of 2008, this was the case after the House rejected a $700 billion bailout plan at the end of September, only for a slightly revised version to be approved days later after the markets plunged. In the present state of affairs, there does not appear to be much cause for concern. The majority of economists surveyed by Trade Algo are confident that the risk of default is very low - under 10% - and that the politicians will ultimately be able to get some kind of fiscal deal that will be linked to an increase in the debt ceiling.  While the price of certain financial contracts that insure against nonpayment of US debts has gone up, investor concerns have been softened by the lack of a precise deadline for resolving the issue, despite the rise in prices for certain financial contracts that insure against nonpayment of US debts.

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Although such a sanguine outlook carries some risks, one of them is that it may backfire on a deal: if people don't believe that the worst will happen, then they may be more likely to stand firm than they were before: It should, however, be noted that going through another tense process may also escalate the risks.