The US debt ceiling - an avoidable volatility event in the making?
It's not a problem until it is, or at least such time that the market looks over the precipice and asks whether Congress has taken it too far – that point could soon be upon us and markets may start to react.We know the US has amassed debts of $28.43t, pushing on the current borrowing cap of $28.4t, which subsequently means Treasury have limited capacity to borrow to pay its debts. We also know that US governments spend in perpetuity – you lose elections if you’re austere and the Democrats will want to capture seats in the Mid-Term election in November 2022.
The DEM’s will likely lose Senate seats if they’re not buying votes into late 2021 and early 2022 period. This means the highly debated and contentious infrastructure and social spending bill will not only need to be passed soon but will need to impacting voters lives in advance of the New Year for it to influence ahead of the Mid-terms.
The government shutdown
The issues at hand are complex and multifaceted – On one constructive footing, House Speaker Pelosi has successfully pushed a Continuing Resolution (CR) through the Senate. Subsequently avoiding a government shutdown and keeping them funded until 3 December – effectively the bill has kicked the can down the street for a couple of months.
The good news is this means the Bureau of Labor Statistics will compile the September US non-farm payrolls report due on Friday (consensus – 500k jobs). Unless it’s a shocker, this could nail the Fed to taper in November.
A vote on Infrastructure is problematic
The next focus in stimulus - As of this moment, House Speaker Pelosi has delayed the $550bln infrastructure package, which is facing resistance from House progressives who want more clarity on Joe Biden’s “Build Back Better” $3.5t stimulus proposal. Senate Democrats, notably Joe Manchin, feel this package is too much and should be closer $1.5t – a number the market is seeing as having a realistic probability of passing in the weeks ahead.
Stimulus talks could be a slow creep on markets and unlikely to cause huge volatility – that said, Joe Biden campaigned to push through these two stimulus packages. A failure to do so may impact his party’s standings in the Mid-Terms. Stimulus also has economic impacts and may impact more cyclical areas of the US market.
Could the debt ceiling cause intense market volatility?
Stimulus talks aside, the debt ceiling debate is a whole different beast though and it would not be hard to see this coming down to the wire and has the potential to cause more intense market volatility. The question is when is ‘the wire’? At what point will the US government exhaust funds from either its Treasury General Account (TGA) or other extraordinary measures? The fact is no one really knows, and the range of estimates varies depending on the authority or economist.
Treasury Secretary Janet Yellen recently suggested that “extraordinary measures” may be exhausted by 18 October.
The Bipartisan Policy Centre projected the so-called “X-date” would arrive any day between 15 October to 3 November.
There are others whose data suggests the hard debt ceiling is just after around 3 November – although, the point at which the US Treasury will face constraints in its ability to borrow from the short-term debt markets would start around mid-to-late October – who wants to lend the US govt money for even weeks when they may technically default in that period?
We’re already seeing US money market funds changing their approach and lending money at ultra-short-term durations and avoiding maturities into the November period.
The market knows the debt ceiling will be raised at some point, but if we head towards mid-October where the negotiations will be deafening and we hear no signs of clarity. The market could ramp up its hedges against a technical default. Naturally, the ramifications of a technical default would be far reaching – where the trickle-down effects of an institution not receiving an interest payment or one’s principal and interest on a maturing debt instrument would have clear knock-on effects through the financial system.
The US government will always make right on its obligations (essentially writing a series of IOU’s), but as we head to mid-October and the market sees headlines of Treasury’s ever-dwindling cash balances, there will be a point when the market says “you, know they’re not going to get it done”. It’s likely just before this point when volatility should ramp up, with equities lower, bond prices and the USD higher (perversely) and the JPY and gold working well.
This ‘X date’ also likely falls amid the meat of US Q3 earnings season and as we approach the November Fed meeting when the Fed will start to reduce the pace of bond purchases.
As we know, the debt ceiling is pure politics and many seasoned traders have the 2011 saga fresh in their memory with the US having a rating downgrade – whether this truly goes to the wire and we see real risk aversion manifest through markets is obviously yet to be seen.
We all know how this ends or at least we think we do, but it doesn’t mean we won't see hedging flows heat up and risk aversion kick up if nothing is agreed as we head into October. A clear event risk to be over and to mark on the calendar, and you can trade the potential opportunity with Pepperstone.
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