An Investor’s Guide to the Looming Debt Ceiling Fight
The fundamental problem is that Congress likes spending and tax cuts, but dislikes debt. This leads to contradictory legislation: expenses and tax bills incompatible with the debt limits it sets. This is not a Democrat versus Republican question. Democrats in fiscally liberal countries can be reelected regardless of debt, and Republicans in fiscally conservative countries will never lose elections by opposing debt. It is the centrists of both parties who need the votes of the fiscal liberals and the conservatives. These are people who want more money from the government and people who are concerned about preserving the value of the money they already have. Moderate and conservative Democrats don’t want to be seen as reckless spenders forcing debt increases without bipartisan support, and moderate and liberal Republicans don’t want to be blamed for government shutdowns and market instability.
The usual assumption is that the center will hold. The cap (currently around $31.4 trillion, leaving $300 billion of wiggle room for borrowing) will eventually be raised or some other workaround found, but fiscal conservatives will get some concessions to cut spending or tighten fiscal rules. However, previous fights against the debt ceiling have taken place during times of economic prosperity, with rising stock prices and low inflation. Republicans emboldened by election success after criticizing Democratic spending may feel like they have a winning hand in forcing a rollback of the Biden administration’s costly policies — earning credit for taming inflation and protected the credit of the United States while showing that the Democrats are ineffective.
I am not a political analyst, so I have nothing more to say on this subject. My topic is the likely market reaction to a deadly fight. Will the possibility of a default send the US dollar and the bond market into meltdowns as almost happened (and may still happen) in the UK? Or will increased fiscal discipline in the US stabilize markets?
One clue is that treasury bill rates from mid-January 2023 to mid-April are up to 0.5% higher than you would expect given the earlier and later maturities. In other words, investors seem to be avoiding these bills. This is the likely time frame for a fight against the debt ceiling, although there are other possible reasons for the yield curve bump. Taken at face value, this suggests that investors are bracing for a significant possibility of major disruption, but not permanent damage. We will know more about this when the results of the November elections are known.
Any fight against the debt ceiling, or even talk of a fight, will drive up short-term Treasury rates and will also drive up other short-term dollar-denominated rates while lowering the value of the dollar. This will increase credit fears in the economy. It could fuel inflation by encouraging people to spend rather than hold dollars and make foreign goods more expensive. This could slow the economy by instilling fear and lowering stock prices.
The worst outcomes are a loss for fiscal conservatives, blunting their future power, or a dysfunctional deal that only complicates matters further and guarantees bigger future fights and continued instability. This could lead to a permanent increase in government borrowing costs, less confidence in the dollar and US credit, and increased debt with weaker controls. It could send the US down a path the UK could have narrowly avoided.
The best outcome, at least for the bond markets, would be agreement on a rational budget process with budget controls allowing Congress to choose and manage the level of debt, and allowing only spending and tax legislation consistent with the level. debt selected. The market is less concerned with the level of indebtedness than whether it is under control and whether it could be reduced if necessary. If the United States has the will to service the debt, no one doubts that it has the capacity. Of course, a perfect solution is unlikely.
The stakes will be much higher in 2023 than in previous debt ceiling fights. Debt and deficits are much larger. True, the 2022 budget deficit was half that of 2021, but it was equal to the largest non-Covid deficit in history, which was the year of the financial crisis of 2009. Moreover, deficits and debt Projected futures, not to mention unfunded budget deficits (mainly Medicare), are much higher than conventional ideas of fiscal prudence would allow. The economy is at least probably in a recession, stocks are in a bear market and inflation is high. If the situation is the same or worse at the start of 2023, we could be close to economic crisis even without the fights in Congress.
Crisis tends to bring out the best and the worst in people. It could provide the fuel for long-needed reforms, or the excuse for a damaging tightrope approach. I’m optimistic in that I think the economy should improve on its own, midterm results will be mixed enough to discourage grandstanding on both sides, and Congress will choose reason over mutually assured destruction. I’m optimistic because I’d rather be happy than afraid, not because I have good reason to hope.
More from Bloomberg Opinion:
• The debt crisis is on the Republican agenda for 2023: Matthew Yglesias
• Another absurd fight against the debt ceiling? No Thanks: Jonathan Bernstein
• Biden hurt, not helped, the economy: Allison Schrager
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Aaron Brown is a former Managing Director and Head of Capital Markets Research at AQR Capital Management. He is the author of “The Poker Face of Wall Street”. He may have an interest in the areas he writes about.
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