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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 the current situation to the 2011 debt ceiling debacle, as the political configuration in 2011 was the same as today: Republicans hold a majority in the House, counterbalanced by Democrats with a majority in the Senate and in the White House. While political posturing may drag this out, as both sides try to position themselves to claim a win, Congress has never failed to raise the debt ceiling – doing so nearly 80 times since 1960. While the political process plays out, the growing risk of a misstep or breakdown in the negotiations could lead to an increase in market volatility.

Many have contrasted the current situation to the 2011 debt ceiling debacle, as the political configuration in 2011 was the same as today.

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 are not 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). 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. 

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 to score political points. Broadly, there appear to be three potential near-term outcomes:

• A bipartisan deal is reached to raise the debt ceiling alongside modest cuts to government spending.
• Moderate Republicans cross party lines and agree to the Democrats ‘clean’ debt limit increase (without associated spending cuts) to avert a default.
• Washington kicks the can down the road, and 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 11th hour, particularly given the now