What’s The Real Issue With The Debt Ceiling?

Politicians just love a crisis that they can leverage to push their agenda and narrative. However, that’s not useful to traders who just want to know what the real world market impact will be.

The current US budget and debt crisis is pretty much just a political issue, but it could spill over into the markets.

So, let’s have a look at what could really happen, and how worried traders should be.

Why is it a problem now?

There is a combination of two issues maximizing the “crisis” pressure.

The first matter is the new budget. Every year Congress must authorize spending for the coming fiscal year, which ends on September 30th.

If there isn’t a new budget, then the Federal government has to “shut down”. This means that essential services will continue, but some things like public parks will close. The last time this happened was in 2019, and during that time the S&P 500 rose by around 10%. So, this isn’t a major issue for the markets.

The second issue is the debt ceiling, whereby Congress puts a limit on how much money the federal government can borrow. Lately, the government has been spending a lot because of covid, which means it has issued a lot of debt.

At the current rate, the government will run out of its ability to issue debt by mid-October. The US has never run out of debt issuance capacity before. And the markets aren’t going to be happy with the associated uncertainty.

What’s this talk about a default?

The government relies on “rolling over” its debt to pay for its current expenses; essentially, issuing new debt to cover the prior debt.

One of the potential consequences of not being able to increase the amount of debt is that the government might not be able to make interest payments, falling into default. That would be really bad for the markets and shake the credibility of the US financial system.

On the other hand, the government could simply not issue more debt and try to run on its current revenue, turning to austerity measures.

Using last year’s figures as a reference, the Federal government was only able to cover 52% of its spending with its income. In other words, “austerity” would mean up to a 48% cut in federal spending. This wouldn’t be as bad for the markets as a default, but would probably mean a new recession. So, it’s still pretty bad.

Is this going to happen?

A default is extremely unlikely. Both parties agree to extending the debt ceiling and funding the government. They are just playing at political brinkmanship to push for their agenda.

Democrats, having the legislative majority and therefore the initiative, have tied raising the debt ceiling to fund the government through a continuing resolution. Democrats want the debt limit suspended until the next election. And this would allow for substantial increases in spending for the next 14 months.

Republicans have counterproposed with a bill that only continues to fund the government, demanding that the Democrats pass a bill to raise the debt ceiling with just their majority.

What will happen?

Economists expect government deficit spending to be a major campaign issue.

The problem is really about the Democrats wanting “bipartisan” blame for raising debt, removing it as a campaign issue for Republicans. On the contrary, Republicans want “party line” blame for raising debt so they can campaign on the issue next year.

The fight will most likely come down to an 11-hour agreement to fund the government and raise the debt ceiling. Or perhaps there will be a couple of days of media consternation while the government shuts down for emergency budget negotiations.

We could see some market volatility towards the end of the month, but it will resolve once the government comes to an agreement.