The bills eventually come due. The U.S. has a self-imposed limit on how much debt it may issue. Congress approved the spending contributing to the debt increase during its annual budget last fall. When the leaves change is when the negotiation period for future spending occurs. For some reason, the number approved for spending does not correspond to an increase in the debt level.
The crux of the matter is not the US’s ability to pay but rather its willingness. As the issuer of the world’s reserve currency, the US enjoys the “exorbitant privilege” of issuing debt in its currency at favorable interest rates.
Before 2011, raising the debt ceiling was a mere formality. I recall writing about this during the first episode of the debt ceiling debates in the summer of 2011. The event spurred worries about a significant increase in interest rates. The opposite happened. Interest rates plunged in a flight to safety trade. Stocks sold off by 20% but bounced back in the year’s final months.
Since then, markets began to view the debt ceiling debate in Washington as the boy who cried wolf. The US hit the debt ceiling in 2015, 2017, 2019, and 2021. While much noise came out of Washington, it always raised the limit. No one wanted to have blood on their hands from seeing the stock market drop or not paying military veterans their pensions.
However, the 2023 debt ceiling seems different from previous iterations. The animosity in Washington and the difficulty in electing a speaker of the House back in January show more dysfunction than usual. It has markets concerned. The price to insure against a U.S. default in one corner of the bond market is now the highest it has been in the last 15 years.
Another concerning development is the widening gap between one-month and three-month Treasury bill rates, with the former trading at significantly lower rates. Investors are wary of holding short-term debt when it matures, as there could be a delay in receiving the principal repayment.
Why is this such a big deal for markets? U.S. Treasury bills form the base of investable assets. It is the risk-free asset of which all other assets price risk and return. The pyramid below conveys this going from private equity at the top as the riskiest to Treasury bills as having the least risk. Treasury bills refer to shorter duration, usually from a few days to a year in maturity. Treasury bonds refer to longer duration maturities, between 10 and 30 years.
Estimates of hitting the debt ceiling moved forward to June or July this summer. Tax receipt collections are running lower than estimated after the recent tax due date in April. Treasury could use extraordinary measures to keep the lights on a bit longer.
It is difficult to make predictions, especially in Washington. We recognize the variability of outcomes in these unknown periods. Eventually, the debt ceiling will rise.
We will continue to monitor the events and data as the debt ceiling approaches. Our approach is to respond to events with the scenario analysis we have already conducted, to thoughtfully position portfolios to protect capital, and take advantage of opportunities.
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