The Big Idea

Putting a debt ceiling showdown on the agenda

Steven Abrahams | January 6, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The first week of January has brought a preview of a likely intersection between politics and markets this year. Some in the new House of Representatives have brought a brawler’s appetite for brinksmanship to electing a new speaker, and that same appetite will likely complicate the process for lifting the federal debt ceiling later this year. That could interrupt a year when volatility should broadly decline. But this episode may include a liquidity squeeze, too.

Deficit politics

A determined group of House Republicans have started the year trying to ensure their party will use its House majority to shape federal priorities, including deficit spending. Scott Perry (R-PA), who leads the House Freedom Caucus, and other caucus members have been among 20 Republications voting against Kevin McCarthy (R-CA) for speaker this week. Perry has said the Freedom Caucus wants votes in this Congress on a number of priorities, including a balanced budget. So, deficit spending clearly is on the agenda.

The group is trying to get leverage over the speaker by asking McCarthy to let any single member of Congress force a new speaker election, a method used in 2015 to force out then-Speaker John Boehner. Democrats changed the rules to allow only party leaders to force a new election. On Friday, McCarthy reportedly had conceded to reinstituting a single-member motion. If one or more members forced a new speaker election as the debt ceiling approached, all House business would stop until the election of a new speaker, including passing new debt ceiling legislation.

Current state of the debt ceiling

The US is close to the debt ceiling now and should hit it later this year. The ceiling stands just below $31.4 trillion with outstanding Treasury debt now at $31.25 trillion. Hitting it depends on the timing and magnitude of federal revenues and expenses, of course, but Congressional Budget Office projections of the federal deficit suggest the US will hit it this year

Once the federal government hits the ceiling and can no longer issue net new debt to raise funds, it still can take extraordinary measures to pay its bill. Those measures include:

Spending some or all the $424 billion in cash balances now held by the Treasury in its Treasury General Account, or TGA, at the Fed
Suspending investment of federal employee retirement contributions
Selling securities held by federal employee retirement accounts

If cash gets exhausted, Treasury would likely start to suspend payments to Medicare, Medicaid, Social Security, veterans benefits and other programs. Some analysts have argued that Treasury could protect Treasury debt by continuing to pay interest. But since Treasury would then be selecting which Congressionally approved spending commitments to honor, protecting the debt market would raise separation-of-powers issues. Absent legislation, the Treasury would likely default on debt.

The US has had disruptive debt ceiling showdowns before

The US has had several debt ceiling showdowns in the last decade or so, all of them resolved and the ceiling lifted before the federal government ran out of money. But the brinksmanship has regularly rattled markets.

The most significant showdown came in 2011, triggered by a group in the House that wanted deficit reduction. On July 31, two days before the Treasury expected to run out of money, President Obama announced that leaders of both parties in both chambers of Congress had reached agreement on terms to raise the debt ceiling. On August 1, a new debt ceiling passed in the House and passed the next day in the Senate, and the president signed it. On August 3, the Treasury raised $238 billion, the largest 1-day increase in US history. On August 5, despite the new debt ceiling, S&P downgraded the US long-term credit rating for the first time in history from ‘AAA’ to ‘AA+’.

As Treasury cash balances declined through the summer of 2011, rate volatility picked up and then spiked in the aftermath of the debt ceiling resolution and the S&P downgrade (Exhibit 1). The rate on the 10-year Treasury dropped 58 bp through August, partly out of concern about the impact of lower federal spending on the economy but also because of the sovereign debt crisis brewing in Europe. Equity prices fell.

Exhibit 1: Rate volatility rose before and after the 2011 debt ceiling resolution

Source: Bloomberg, Amherst Pierpont Securities

A second big showdown on the debt ceiling came again in 2013 and resolved on October 16, a day before the government expected to run out of money. The market response in 2013 was more muted possibly because of experience with the 2011 episode. Other efforts to hold the debt ceiling hostage have come around regularly, including in 2021, but few have gained traction.

The seeds of a liquidity squeeze

One possible complication of a showdown this year is the ongoing drawdown in system liquidity through the Fed’s QT. If the Treasury resorts to extraordinary measures and spends down the cash in the TGA, it may have to quickly issue debt and restock balances once the ceiling gets lifted—similar to the sharp issuance at the end of the 2011 crisis. Lou Crandall, chief economist at Wrightson ICAP, points out that this could trigger a sudden and sizable drain on cash balances held as bank reserves, in money market funds or at the Fed’s RRP facility. Banks could offset any sudden pressure by raising deposit rates, issuing CDs, doing term repo or even borrowing from the FHLBank system. But banks already concerned about the impact of QT and unable to move quickly enough as Treasury restocks the TBA may resort to liquidity hoarding, and that could ripple through financing markets.

Volatility otherwise should broadly decline

Absent a likely debt ceiling showdown later this year, rate volatility should decline from the extraordinary levels of 2022. That volatility reflected historic uncertainty about the direction of the economy—signaled by historic dispersion in economists’ forecasts—and, consequently, historic uncertainty about Fed policy. This year should show the impact of the Fed’s tighter policy and should bring hikes at least temporarily to a halt. The market should get valuable information about the effect of policy on the economy, and the range of economic and policy outcomes should narrow. Actual and expected volatility should drop.

Investment implications

Falling volatility should help risk assets this year, much as it did in the last quarter of 2022. But a debt ceiling showdown could interrupt the broad trend. Investors can hedge the likely market impact by getting long vol for the appropriate dates, although it is hard at this point to predict exactly when.

Investors may also want to lock in funding ahead of the aftermath of any expected debt ceiling resolution. Again, timing is hard to predict.

What seems easier to predict is that a debt ceiling showdown is coming again this year. It’s only the first week of January, but it seems some legislators are already warming up for the event.

* * *

The view in rates

OIS forward rates now price for peak fed funds around 5% in June with more than 40 bp of cuts by the end of year. The cuts run contrary to Fed Chair Powell’s steady warnings that the Fed will hold rates high through next year. That sets up the market for volatility next year if Powell sticks to his guns. But the broad volatility trend still should be down.

Fed RRP balances closed Friday at $2.20 trillion, roughly the average since June. RRP balances exploded to a record $2.55 trillion on the last day of 2022, likely as banks chased deposits off their balance sheets for the final reporting day of the year.

Settings on 3-month LIBOR have closed Friday at 481 bp. Setting on 3-month term SOFR closed Friday at 465 bp. The spread between 3-month SOFR and LIBOR has renormalized after spiking in early October.

Further out the curve, the 2-year note closed Friday at 4.25%. The 10-year note closed well above fundamental fair value at 3.56%, so the higher yield has to get chalked up to a market seeing or expecting supply to overwhelm demand. It is shaping up to be a long and volatile winter for the rates market.

The Treasury yield curve has finished its most recent session with 2s10s at -69 bp. The 5s30s finished the most recent session at -1 bp. The 2s10s curve looks likely to invert by around 100 bp shortly before Fed tightening comes to an end. That is a trade for some time next year.

Breakeven 10-year inflation finished the week at 221 bp. The 10-year real rate finished the week at 134 bp.

The view in spreads

Volatility should continue while the Fed’s path stays in flux. But volatility should drop sharply next year as the market sees more on the path of inflation and the impact so far of Fed policy. Both MBS and credit tightened through November but stayed roughly flat in December. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields has dropped from more than 170 bp at the start of November to close Friday at 136 bp. Par 30-year MBS OAS has dropped from more than 60 bp to close Friday at 15 bp. Investment grade cash credit spreads have dropped from more than 180 bp bp over the SOFR curve to close Friday at 160 bp

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates, and health stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. A recent New York Fed study argues inflation generally helps companies lift gross margins, although airlines and leisure may have an easier time passing through costs than healthcare, retail and restaurants. But in leveraged loans, a higher real cost of funds has already started to eat away at highly leveraged balance sheets with weak or volatile revenues. The leveraged loan market is the bellwether to watch for broader corporate and consumer credit, and stress in leveraged loans looks likely to spill over into CLOs.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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