The White House and Congress are trying to reach a deal before the August recess, as recent studies suggest that the money will run out in early September. Using the 2011 debt ceiling fight as an example, equities may be vulnerable near-term, while the outlook for bonds and the dollar are not so clear-cut.RECENT DEVELOPMENTS
The February 2018 suspension of the US debt ceiling expired this March. This means that a dysfunctional Congress has been tasked with a compromise that heads off a potential technical default when current stopgap measures run out after the summer. Lower than expected revenues have moved the so-called drop-dead data from November to October and most recently to early September.
Indeed, sluggish revenues and rapidly rising expenditures saw the 12-month deficit rise to nearly $1 trln in May before easing back to $919 bln in June. We believe the total will resume increasing this year. The July budget statement will be released August 12 and will provide an early glimpse of H2.
A compromise remains elusive even as talks kick into high gear. Treasury Secretary Mnuchin claimed Monday that the White House and congressional leaders were “every close” to a deal that would raise the debt ceiling and set spending levels for the next two fiscal years (FY2020 and FY2021). White House officials have been trying to push the idea of separating these two issues, so that the ceiling could be raised even if they fail to settle on spending plans. Speaker of the House Pelosi has signaled that the two matters will not be separated.
Time is of the essence. The most recent non-partisan analysis suggests the government will run out of money sooner than expected, perhaps in early September. Congress is in summer recess from August 4-September 6. When both chambers return September 9, that leaves no time to get a deal done before the money runs out.
A BRIEF HISTORY LESSON
The first debt ceiling fight began in 1953, when President Eisenhower faced a revolt by the Republican-controlled Senate. Eisenhower wanted more funding to build the national highway system, but Congress had become alarmed at the buildup in the national debt during WWII. After much wrangling and some emergency measures taken by Treasury, the debt ceiling was raised in 1954. It turns out that the ceiling has very little real meaning, having been raised more than 80 times since 1959 under administrations from both parties.
Starting in 2013, Congress has temporarily suspended the debt limit rather than raising it directly. This has been done five times. A suspension allows Treasury to borrow as needed during that time to meet all its obligations in full and on time. When the suspension ends, the amount borrowed during that suspension is added to get the new ceiling. The debt ceiling was $20.456 trln when it was suspended back in February 2018. It went back into effect this March, with the new ceiling established at $22 trln.
With the ceiling is reached, the Treasury cannot issue any new debt. However, as we’ve seen in the past, that doesn’t mean that the government can no longer fund itself. Through various accounting tricks, Treasury is able to continue making payments by so-called “extraordinary measures.” As those measures become exhausted, however, there is increased risk of a technical default. That is where we stand now.
The 2011 fight over the debt ceiling is worth mentioning. This was widely regarded as the first time that the debt ceiling was utilized in a partisan manner in a fight about budget policies. The showdown took place as the new Republican House came into power after the November 2010 midterm elections. A “clean” bill that would raise the ceiling with no strings attached was soundly defeated in the House 318-97 on May 31.
Eventually, the House was able to force spending cuts of $900 bln over ten years in exchange for an increase in the debt ceiling. This compromise was contained in the Budget Control Act of 2011, which passed in the House August 1 by a vote of 269-161 and in the Senate August 2 by 74-26. Even though a shutdown was avoided, the drama still led to the first ever downgrade for the US by S&P on August 5.
Despite market concerns about a US recession, the data simply do not support such a negative outlook. The labor market remains strong, which in turn is very supportive for consumption. After the stronger than expected June retail sales report, Atlanta Fed’s GDPNow model is tracking Q2 growth at 1.6% SAAR, up from 1.4% previously. NY Fed’s Nowcast model currently has Q2 growth at 1.5% SAAR, but this is likely to be revised up this Friday.
The first official estimate for Q2 GDP will be reported July 26 and Bloomberg consensus is currently at 1.7% SAAR. While a slowdown from Q1 (3.1% SAAR) was to be expected, such a reading would be close to trend growth (~2%). Markets will remain particularly sensitive for signs of a larger than expected drop-off but for now, a US recession seems particularly far off. The US curve continues to flirt with a positive slope, reflecting these reduced recession risks.
Many (including us) continue to question the need for a Fed rate cut. Yet Powell has painted the Fed into a corner and a cut this month seems as close as one can get to a done deal. It’s the back-month expectations that need to be adjusted, as the implied yield on the January 2020 Fed Funds futures contract of 1.70% still suggests two more cuts are expected after this month.
When market expectations readjust for a less dovish Fed, it will be dollar-positive, equity-negative, and bond-negative. Indeed, we retain our bullish dollar call for H2 2019, but we expect to be tested many times on our conviction until these current recession fears fade away. Shorter-term, we think the dovish tilt in the Fed will be a headwind on the dollar until the medium-term outlook for Fed policy becomes clearer.
Of course, these broad macro investment calls are all predicated on a continued economic expansion in the US. If the economy slows or goes into recession, then the Fed will have no choice but to alter its rate path and cut rates more aggressively then we are anticipating. If so, this would be a game-changer for the dollar. Why? Because the policy mix would change from the current dollar-supportive one (tight monetary and loose fiscal policy) to one that is dollar-negative (loose monetary policy and tight fiscal policy).
Back in April, we wrote that the US had improved modestly and moved back (barely) into AAA territory. It has been going back and forth between AAA and AA+ for several quarters and bears watching. In other words, the US was already skating on thin ice as it moved into the current debt ceiling fight.
Fitch warned back in January that the shutdown and any subsequent problems with the debt ceiling would hurt US creditworthiness. Fitch official said that the policy framework and the inability to pass a budget may not be consistent with a AAA rating.
Moody’s said earlier this year that the base case is that Congress and the White House come to an agreement before the debt ceiling becomes an issue. If so, Moody’s said its Aaa rating would remain intact. Yet, if this doesn’t prove to be the case and there is a technical default, it would seem that a downgrade becomes more likely.
As we’ve seen, brinksmanship over the debt ceiling can have serious consequences. All three rating agencies moved the US outlook to negative during the 2011 debt ceiling fight. However, S&P was the only one to downgrade the US for the first time ever on August 5, 2011. The US was cut one notch to AA+, and the agency cited Washington gridlock as well as the lack of an agreement to contain the growing debt load for its decision to downgrade. S&P also noted then that no country has regained AAA in less than nine years.
US stocks sold off both before and after this downgrade. After posting a low for that move in early October 2011, US stocks then recovered and embarked on a multi-year rally that lasted until mid-2015 before a correction set in. If the US can avoid a recession, we suspect this pattern may be repeated for the current debt ceiling battle.
The impact of potential downgrades on either the US Treasury market or the dollar is not so clear. After S&P downgraded the US in August 2011, the 10-year UST yield spiked temporarily but then went on the make new lows before reversing higher a year later. Similarly, the dollar softened slightly ahead of that downgrade but then went on a tear for the rest of the year and well into 2012.
Bottom line: given all the current uncertainty regarding the US economy and Fed policy, the last thing the markets need is an added dose of uncertainty regarding the debt ceiling and a potential technical default by the US.