Debt ceiling deal…or no deal

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[ "Joshua Kutin", "Edward Al-Hussainy" ]
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Potential market outcomes — from most to least likely scenarios.

The U.S. is once again coming up against its debt limit and the prospect of a default. While consensus expectation is that we’ll see a last-minute deal to avoid breaching the limit, we consider potential market outcomes — from most to least likely scenarios.


If the debt ceiling is raised via a last-minute deal, we expect higher volatility and wider credit spreads as we approach default, and then a market rebound once a deal is struck. If Congress agrees to raise the debt limit by a small amount, buying more time, we expect higher and more extended volatility as negotiations drag on. On the other hand, if there is a Technical Default -- where the U.S. Treasury will not have enough cash on hand to meet all obligations on time and in full, and will have to prioritize payments and potentially delay payout of principal/debt service – or Executive Branch action – where the President could invoke the 14th amendment, on the theory that a default is not permitted by the constitution – we expect a risk-off environment. We could see spikes in equity volatility, a weaker US dollar, and wider credit spreads within fixed income. Long-term Treasuries would usually rally in a risk-off event like this, but because Treasuries are at the center of the default story, we could see them sell off.


A protracted period of debate or default could begin to damage the standing of the U.S. in global markets, impacting the standing of the U.S. dollar as a reserve currency and the relative appeal of the U.S. versus international equity markets.

There’s also impact for the real economy. In a protracted technical default, the government will need to balance the budget, leading to a cut in spending equal to the size of the deficit (currently 5.3% of GDP*). This would result in a deep recession.

Other creative solutions have been floated, including minting a $1 trillion coin to be deposited at the Fed and then using the proceeds for payments, liquidating non-marketable securities from government pensions, and issuing premium bonds. We believe these are unlikely.


The bottom line

The base case scenario is that an agreement is reached — likely at the last minute — and we still expect higher volatility as rhetoric heats up. In 2011, the rating of U.S. debt was downgraded due to debt ceiling brinkmanship. There could be longer term implications once again, especially if the rest of the world grows tired of our repeated debt ceiling crises.


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