Monday 23 January 2023
Paradoxically, the future clash over the debt ceiling is positive for the markets in the short term
It is very likely that a very intense political battle will take place in the United States over raising the debt ceiling. This would pose risks to the US economy and to financial stability. But paradoxically, this should have positive consequences for the financial markets at first because it will free up liquidity.
It took 15 votes for Kevin McCarthy to be elected House Speaker, making it the longest election in 164 years. To achieve this, McCarthy had to make concessions to the ultra-conservative MPs (Freedom Caucus), including the ability for a single MP to trigger a vote of no confidence in McCarthy but also the fact of demanding budget cuts in exchange for any raise of the debt ceiling. Future negotiations on raising the debt ceiling therefore promise to be very complicated, because it will be difficult to find an agreement between Democrats and Republicans on the one hand, but also within the Republican camp on the other. The public debt has already reached in ceiling around mid-January but the Treasury has still some cash at the Fed and will trigger extraordinary measures. Cautiously, Treasury Secretary Janet Yellen indicated that any risk of default on federal debt is unlikely until early June. Given the level of political polarization, it is unlikely that a solution will be found by then.
See Appendices – Graph 1
A bad thing for the US economy in the medium term
The fact that the public debt is reaching its ceiling is a bad thing for the US economy and gives rise to a number of risks: in this situation, the Treasury can no longer issue debt to finance expenditure and exceptional measures are put in place implemented to avoid a default on existing debt, such as suspending local government debt issues, stopping contributing to certain public pension funds, implementing the sale of assets or stopping the payment of salaries to civil servants. The prospect that the United States could default on its debt is potentially destabilizing for financial markets in general, and not just in the United States, because Treasury securities are generally considered the safest asset in the world and the backbone of the global financial system.
Several famous episodes of political battles over the debt ceiling have taken place. We can, for example, mention the episode of 2011, which lasted a large part of the year and during which the S&P agency lowered the rating of the United States from AAA to AA+. The S&P 500 index had lost more than 15% in the final days of the debt ceiling crisis, due to growing fears of a possible default. Another crisis relating to the debt ceiling lasted much of 2013.
Paradoxically, a positive element for the short-term markets
Over the period that will precede the political confrontation, that is to say roughly the first half of 2023, the fact that the financial situation of the US Treasury is becoming more complicated should paradoxically be a positive element for the risky asset markets. As we will see, this relates to “central bank” liquidity conditions.
Let's take stock: on January 19, 2023, the Treasury held $456 billion in its account at the Fed (the so-called Treasury General Account, TGA). Negotiations on the debt ceiling will likely take place in the summer when the TGA approaches zero. This is exactly what happened at the end of 2021: in the months preceding the agreement on the debt ceiling reached in mid-December 2021, the TGA had converged to zero and commercial bank reserves at the Fed had risen sharply. This corresponded to a release of "central bank" liquidity. Once the agreement was reached, the US Treasury was able to issue Tbills on a massive scale: in January and February 2022, the Treasury account at the Fed had been replenished and through a communicating vase effect, the reserves held by the commercial banks had then fell (we can take the example of a bank purchasing Treasury securities with their reserves). This had corresponded to a strong withdrawal of "central bank" liquidity even before the Fed formally began its balance sheet reduction (Quantitative Tightening). The tax receipts collected in April 2022 (fiscal season) had led to a new sharp increase in the Treasury account and a new sharp drop in the reserves held by commercial banks at the Fed.
See Appendices – Graph 2
One cannot help but note the coincidence of the replenishment of the TGA (and therefore the fall in the reserves held by commercial banks) with the fall in the financial markets. Obviously, other factors had contributed to the fall in the equity markets, such as the signal sent by the Fed at the start of 2022 that the institution was considering a balance sheet reduction policy (QT) or the speech on April 4 2022 by Fed Vice Chair Lael Brainard, in which she hinted at a quick QT.
See Appendices – Graph 3
In the first quarter of 2023, the situation should at least resemble that of the last months of 2021: liquidation of the TGA and stabilization, or even rise in reserves held by banks. This development should play a positive role for the equity markets, in the same way as the fact that the Fed should become less aggressive in its rate policy (rate hike of only 25 bps in February?). On the other hand, the tax payment period in April should temporarily raise the level of the Treasury account at the Fed.
In the United States, discussions about the debt ceiling should be a common thread in the year 2023, as in 2011, 2013 or even 2021, and the very difficult election of Kevin McCarthy as House speaker shows that extreme political scenarios cannot be ruled out. The risks directly linked to a non-raising of the debt ceiling should not initially affect the financial markets. Paradoxically, this problem could even have a positive effect on the short-term markets since the fact that the Treasury account converges towards zero corresponds to a release of liquidity. As in 2022, developments relating to “central bank” liquidity will be decisive for the evolution of the markets and the question of raising the debt ceiling will play an important role.
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Bastien Drut, Chief Thematic Macro Strategist