- An early-June deadline to raise the US federal debt ceiling looms large. An agreement is needed to increase how much money the federal government can borrow so that it can make payments on time.
- A default has severe repercussions for global financial markets; US bonds are recognised to be among the safest investments and a significant amount of global financing is priced in USD, the world’s reserve currency.
- Raising the US debt limit is subject to agreement from the US lawmakers, and while it was set up as a routine event, it gets challenging when Congress is divided — which is the case now.
- Fund managers see a highly remote chance of a US bond default, but warn that the situation may undermine financial markets in the country and globally, at least in the short term.
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All eyes are on US lawmakers as an early-June deadline to raise the US federal debt ceiling looms large — with US Treasury Secretary Janet Yellen warning in May about the financial consequences if the debt ceiling debate is left unresolved.
The debt ceiling is more simply explained as the cap on how much the federal government can borrow via banks, investors, and foreign countries, among others, to pay the nation’s bills. It can use the money for obligations such as debt interest payments, wages of government employees, and welfare benefits. The “X date” — or the estimated deadline for which the US Treasury can no longer make payment on its debt obligations — is as early as 1 June 2023, according to Yellen. (There is uncertainty over the exact deadline because of the fluid nature of tax collections and fiscal payments.)
The US national debt currently stands at more than US$31 trillion. A default has severe repercussions for global financial markets. That’s as US bonds are recognised as among the safest investments in the world and a significant amount of global financing is priced in US dollars (USD), the world’s reserve currency. So a default — even if a technical one — may shake the confidence of the global financial system.
Raising the country’s debt limit is subject to agreement from the lawmakers. And while it was set up as a routine event, it gets challenging when Congress is divided — which is the case now. The Republicans control the House of Representatives, while the Democrats command the Senate. Republicans want concessions to curb federal spending, while Democrats want to stand pat on the matter.
Investors are watching to see if the debt ceiling debate will escalate to be as contentious as that in 2011, when the US averted a debt default within just 72 hours ahead of the deadline.
How will this latest clash impact markets? Fund managers weigh in.
Potential for US debt ceiling crisis to destabilise markets
UOB Asset Management, 8 May 2023
“The timeframe for averting a crisis is already shorter than earlier anticipated… at this stage, the chances of a US bond default cannot be ruled out but still appears highly remote. But even without a default, current uncertainties and fiscal implications could undermine financial markets in the US and globally, at least in the short term.”
“Back in 2011, faced with a similar debt ceiling crisis, but also weakening economic indicators, the S&P 500 declined by 17% in the three weeks prior to the deadline. This time around, US equity markets may be more resilient if the country is able to show positive growth and earnings surprises, or a Fed pivot materialises. On the other hand, having already rallied this year, market gains look vulnerable to profit taking amid these gathering storm clouds.”
Debt ceiling showdown: Should investors worry?
Capital Group, 28 April 2023
“The worry is that the US could — in the middle of a particularly nasty debt ceiling impasse — wind up in technical default on its many debt obligations, including payments to bondholders. It’s hard to predict what might happen next, but there are many who say it would roil the financial markets and jeopardise the US dollar’s status as the world’s reserve currency.”
“The chances of a technical default — which would occur should a bond payment be missed or even delayed — are very low but not zero… The rating agencies could slash the US credit rating again. Investors could drive up the cost of future US debt issuances. And, perhaps worst of all, some investors may no longer regard US Treasuries as the safest investment in the world.”
Debt ceiling debate: Examining risks around the X date
PIMCO, 27 April 2023
“We do not expect a default, but we also do not expect a resolution until the eleventh hour and very likely will see some market volatility beforehand… while risk market performance has usually retraced after a resolution, we could nevertheless see a lingering impact in the cash markets even after a debt ceiling deal. We suggest investors keep an eye on liquidity costs and conditions even after a debt ceiling deal.”
“The Treasury will likely look to rebuild its cash balances, which will continue to be spent down in anticipation of the X date, and we should expect T-bill supply to increase substantively — perhaps by US$1 trillion or more — after a deal. This significant issuance will take excess liquidity out of the market ahead of year-end. Although a reasonable amount of this cash would be offset by a reduction in the Fed’s RRP (reverse repurchase agreement, or reverse repo) balance, there may be implications for broader costs for funding and liquidity across capital markets.”
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