“A billion here, a billion there, and pretty soon you’re talking about real money.” –Senator Everett Dirksen
Admittedly, the debt ceiling showdowns are not my favorite thought exercises. Given the unpredictability of American politics, especially as of late, the risks of an actual default are next to impossible to handicap ex-ante. It’s one of those tail risks in which a small probability times a large impact equals an expected value that cannot be ignored. So, with the date potentially less than a month away, we consider both the immediate technical and lasting economic consequences of a resolution, one way or the other.
Our base case is not default. We still believe that a work-around or even a bilateral agreement will be struck to avoid the worst. But that doesn’t mean it won’t get bumpy and a grand bargain won’t have consequences for an already jittery market. On Monday, Janet Yellen warned that the so-called “X-date,” or the date that the government would no longer have funds to meet all its daily obligations, could be as soon as June 1st. In response, the one-month Treasury Bill market moved over 200bps higher over the course of the last four trading days! Clearly, the market is starting to take this seriously.
Compounding the risk of missed payments is the potential that the rating agencies could downgrade U.S. Sovereign Credit. Fitch has led the charge, warning that even prioritization of payments (e.g., withholding hospital, municipal, and/or social security remits in favor of making principal and interest (P&I) payments on U.S. Treasuries) would still necessitate a downgrade from AAA. Moody’s mentioned that it would take an actual default (missed P&I payments on U.S. Treasuries) to downgrade, while S&P has remained silent.
Our questions of concerns are two-fold: 1) what would be the technical impact of a default on market operations? and 2) what would be the lasting impact on the economy if a ceiling-raising agreement significantly curtails fiscal spending?
Regarding (1): Away from the jarring headline “AMERICA DEFAULTS,” stoppages in cash received on interest and principal payments in arguably the most widely owned debt sector in the world would send shockwaves through back-offices on multiple continents. In 1979, the U.S. Government missed payments totaling $122 million on Treasuries due to clerical mistakes, but eventually made investors whole on accrued interest after facing a plethora of lawsuits. In 2023, the potential size of missed coupon payments is much higher – averaging several billions of dollars per day. It’s possible that the Federal Reserve sets up a swap facility for the defaulted issues, but many holders would be unable to take advantage due to local laws, tax consequences, and/or operational limitations. Furthermore, the tradability of such issues would be thrown into limbo. Bloomberg assumes that maturities with missed principal payments would be extended on a day-to-day basis so that they could remain tradable while outstanding. The U.S. Treasury has yet to confirm this work-around.
Regarding (2): The secondary impact on the fragile U.S. economy concerns us on a fundamental basis. A dramatic shift in the fiscal trajectory of the U.S. Government could easily throw us into a severe recession. Pivoting to a form of fiscal austerity would compound the slow down already underway from monetary policy tightening. The risk is that we’d be slamming on two sets of brakes at once – and the flight to quality, liquidity, and safety would be exacerbated in short order. The yield curve would likely rally in dramatic fashion, while dry powder and nimbleness would be at a premium across the fixed income universe.
But the next thirty days can mean a lifetime of news. In 2011, the Treasury allegedly constructed an elaborate plan to mitigate the impact from a default. One must presume they’ve dusted that plan off. Furthermore, Congressional leaders have floated ideas of a bridge agreement to buy more time for constructive negotiations. And lastly, the Constitutionality of purposely missing P&I payments under the 14th Amendment could be challenged in front of the Supreme Court. Nothing is certain even, this close to the deadline. Stay tuned.
As of 5/4/23. The views contained in this report are those of Income Research & Management (“IR+M”) and are based on information obtained by IR+M from sources that are believed to be reliable but IR+M makes no guarantee as to the accuracy or completeness of the underlying third-party data used to form IR+M’s views and opinions. This report is for informational purposes only and is not intended to provide specific advice, recommendations, or projected returns for any particular IR+M product. Investing in securities involves risk of loss that clients should be prepared to bear. More specifically, investing in the bond market is subject to certain risks including but not limited to market, interest rate, credit, call or prepayment, extension, issuer, and inflation risk. It should not be assumed that the yields or any other data presented exist today or will in the future. It should not be assumed that recommendations made will be profitable in the future. Actual results may vary. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.