Special market commentary: Debt ceiling negotiations in focus

April’s tax receipts came in lower than expected, which has accelerated the likely deadline to raise or suspend the $31.4 trillion U.S. debt limit. Both Treasury Secretary Janet Yellen and the Congressional Budget Office have recently suggested that early June is the revised estimate for when the Treasury Department’s “extraordinary measures” will run out. While not definitive, if this deadline proves true, policymakers will soon face increased pressure to break the impasse and come to an agreement to raise the debt ceiling and avoid a default.

President Biden and House Speaker McCarthy met on Tuesday to discuss a potential path forward, but no substantive progress appears to have been made toward a near-term agreement. The parties will reconvene on Friday. At this point, policymakers on both sides of the aisle have been very clear to state they will NOT allow a default. However, many have contrasted current events to the 2011 debt ceiling situation, as the political configurations are the same: Republicans hold a majority in the House, counterbalanced by Democrats with a majority in the Senate and in the White House.

Many have contrasted current events to the 2011 debt ceiling situation, as the political configurations are the same.

It’s important to note that Congress has never failed to raise the debt ceiling — doing so nearly 80 times since 1960. However, the more time it takes to work through the political process and make a decision, the greater the risk is of a misstep or breakdown in the negotiations, which could lead to an increase in market volatility.

Will the debt limit be raised?

The specific path to a resolution is difficult to predict and will likely hinge on how hard each side digs in. Broadly, there appear to be three potential near-term outcomes:

1. A bipartisan deal is reached to raise the debt ceiling alongside modest cuts to government spending.
2. Moderate Republicans cross party lines and agree to the Democrats debt limit increase (without associated spending cuts) to avert a default.
3. A deal is reached to temporarily suspend the debt ceiling until a later date.

In any of those scenarios, it’s likely the process will draw out to the eleventh hour, particularly given the now abbreviated time frame until the potential “X-date” when the government would exhaust its ability to spend without issuing additional debt. The House’s ability to push through legislation to raise the debt limit for one year alongside spending cuts increases the likelihood that the Biden administration and Congressional Democrats may have to concede on some spending caps or cuts. Given the shortened time frame and rapidly approaching estimated deadline to act, there’s a growing sense that the path of least resistance may be to delay a decision to a later date via a temporary suspension.

In any of those scenarios, it’s likely the process will draw out to the eleventh hour.

Ultimately, we expect that the debt ceiling will be raised or at least suspended. The consequences and negative economic and political fallout from inaction should provide incentive for both sides to reach an agreement. Whether that comes in time to avoid even a temporary delay in payments remains the question.

What are the potential ramifications of a technical default?

Missing the deadline could lead to a brief stoppage (technical default) of federal payments, but it’s likely to create enough volatility and public backlash that some sort of bipartisan deal would be reached in short order. While it’s impossible to definitively say how global markets would react to a technical default, the breadth and magnitude of economic and market fallout will likely be very dependent upon the sense of progress being made as the deadline nears and the avoidance of even a temporary delay in payments. From a capital markets perspective, avoiding a temporary delay in the payment of principal and interest on Treasuries will be paramount.

While the potential outcomes in a default scenario are all speculation, several ripple effects could be reasonably anticipated:

• Direct hardship for millions of Americans who rely on payments from the government, including Social Security payments and federal employee and veteran benefits.
• A potential downgrade of the U.S. credit rating by one or more of the bond rating agencies (and damage to the perceived global leadership position of the United States.)
• An uptick in Treasury yields higher, at least temporarily, increasing borrowing costs further. (This is already apparent in the yield for those securities maturing in early June.)
• Some degree of dollar devaluation relative to other currencies, although the effect would likely be temporary.
• Increased volatility in U.S.-based risk assets broadly at least until the effects of the disruption can be assessed.

To the extent that the disruption lasted beyond even a few days, the above factors would contribute to a further slowdown in economic growth. While there’s no way to estimate the actual prioritization of payments or duration of any stoppage of payments, the longer the impasse, the greater the impact.

Are there concerns around money market funds?

Assets in money market funds are managed in a fiduciary manner, and the potential concerns with Treasuries maturing over the June-August time frame are well understood. When the last significant debt ceiling showdown occurred in 2011, managers navigated around the risks of a potential default and appear to be taking similar risk-minimizing strategies today. There are indications that many money funds are avoiding Treasury issues maturing during that period in an abundance of caution. The upward kink in yields at the beginning of June seems to point squarely at that.

Banking sector turmoil continues

While negotiations on the debt ceiling remain in focus, turmoil in the banking sector has persisted with First Republic’s failure in early May marking the latest institution to fall and the second largest bank failure in history. While not as rapid as the March collapse of Silicon Valley Bank, the steady bleed of deposits (a large portion of which was above the FDIC insurance limit) ultimately led to its inability to continue. The news of the bank’s closure was of little surprise and J.P. Morgan’s decision to purchase most of the bank’s assets facilitated a relatively smooth transition and helped to ease volatility.

Still, the risks within the banking sector aren’t completely in the rear-view mirror. Although the large systemically important money center banks appear to be on a solid footing, ongoing challenges within the small and regional banking sector may persist. Many are experiencing an outflow of deposits to both larger banks (that are viewed as potentially safer) and to money market funds that offer an attractive relative yield. Declining deposits, higher funding costs, declining security portfolio values, an increase in probable loan losses, and the potential for greater regulatory scrutiny are all contributing to an ongoing tightening in lending standards, which had already begun to tighten late last year (as we illustrate in a recent commentary). There is growing evidence that loan demand is slowing, and banks are curbing lending, at a time when the economy is already showing signs of a slowdown. Importantly though, the G-SIBs (Global Systemically Important Banks) appear well capitalized, have undergone considerable stress testing, and have been beneficiaries of some of the recent outflows from regional banks, which could strengthen their relative position and help provide stability to the banking sector.

What should investors do?

Given a slower growth backdrop, tight financial conditions (that are likely to tighten further given developments in the banking sector), growing evidence of a notable slowdown in demand for credit, tighter bank lending standards, and the looming debt ceiling, the potential for heightened volatility certainly exists. Investors should consider the following:

• Maintain diversification. Be prepared to lean into volatility via rebalancing and tax-loss harvesting and ensure the adequacy of cash reserves. If you expect to tap your portfolio for spending needs in the coming six to 12 months and don’t already have the liquidity that will be needed, raising cash now would be appropriate. However, it’s still important to ensure bank cash balances remain below the FDIC deposit insurance limits to mitigate risk. Treasury money market funds remain a viable alternative.
• Reaffirm your current risk level and asset allocation. The considerable increase in bonds yields have lifted expected returns for balanced portfolios. With bond portfolios now contributing more to portfolio-level returns, it may be possible to modestly reduce equity exposure while still targeting an expected return that’s comparable to the return expectations of even a year ago.
• While it’s possible that foreign, nondollar denominated investments could benefit on a relative basis (as a weaker dollar could benefit foreign stocks and bonds and precious metals at the margins), an extended period of disruption would send ripples through the global economy as well, so it’s unlikely that foreign markets would be immune. While every cycle is different, there’s no guarantee that foreign markets would outperform given the dollar’s role as a comparative safe haven, particularly if a default is ultimately avoided or brief.

We’ll continue to monitor the situation closely, evaluate any additional steps that may be appropriate, and keep you informed of any developments that we deem to be material. We expect that the attention to the debt ceiling negotiations will intensify as the deadline nears, particularly if progress appears limited. We still believe that an agreement will ultimately be reached but recognize that the environment in Washington could make the process a challenging one. If you have questions or concerns, please don’t hesitate to contact your relationship manager.