Tom Wald, CFA®, Chief Investment Officer, Transamerica Asset Management, Inc.
In this article we review:
The current state of the U.S. debt ceiling negotiations and the default risk it has created
Recent trading in the U.S. Treasury bill market reflecting some degree of delayed payment risk
The timing involved regarding an agreement being reached and passed by Congress
Why the 14th Amendment is unlikely to be a successful route in bypassing the debt ceiling limit
How we see the current impasse between the parties, President Joe Biden and House Speaker Kevin McCarthy, likely playing out
Since 1789, the United States Treasury has met all interest and principal payments on the country’s debt, having done so through wars, depressions, pandemics, and the transfer of power. However, a current impasse between the political parties regarding a necessary increase of the U.S. debt ceiling (the legislative amount of national debt that can be incurred by the U.S. Treasury) has now brought the prospect of default, something previously deemed unimaginable for over two centuries, closer to the brink of occurrence than at any time in the nation’s history.
While odds still likely favor a deal between President Joe Biden and House Speaker Kevin McCarthy will come to fruition and pass both chambers of Congress by the loosely configured deadline of June 1, such probabilities are now declining with each day the debt ceiling remains unresolved. At that point, the U.S. Department of Treasury will need to make payments on the next scheduled round of interest and principal payments on Treasury bills, notes, and bonds, as well as numerous other obligations ranging from Social Security to Medicare.
To say the least, a U.S. default, even one lasting no more than a few days, would likely send unprecedented and devastating reverberations across the world economy and global markets. It is for this reason many simply assume President Biden and Speaker McCarthy, and the leaderships of their respective parties, will have no choice in the end but to come to an agreement if for no other reason than to avoid mutually assured economic destruction.
In light of this emerging tail risk, which grows in tension by the day, important points for investors to consider include the following:
The U.S. Treasury bill market is now reflecting some degree of delayed payment risk. Yield spreads between Treasury bills maturing prior to June 1 and thereafter have now dislocated to historic margins. As of the May 23 market close, the May 30 T-bill maturities were trading at annualized yields of approximately 2.19% versus dramatically higher June 15 maturity yields of 6.2%. It’s clear the markets are now differentiating the risk of Treasury securities with principal payments before and after June 1, with those maturing between June 6–June 15 trading with the highest perceived risk of a delayed payment. In broader markets, stock prices and corporate bond credit spreads have yet to experience meaningful changes from recent trading levels, although this of course could change as June 1 nears.
Fundamental and long-running differences between the parties remain at the heart of the disagreement. Hard dollar spending cuts, allocations of military versus domestic discretionary spending, and revenue to be raised via tax increases remain as key sticking points in the negotiation and are emblematic of major ideological differences between the parties and thus continue to be roadblocks in finding common ground. Without question, concessions will need to be made soon from both sides.
Timing is coming down to the wire. Speaker McCarthy has stated that members of Congress will need 72 hours to review any agreement before holding a vote. Taking this into consideration, the window available to strike a deal is now a matter of days. While the market consensus clearly remains that a deal will be struck and approved by the House and Senate, that consensus now also seems to include that it may not occur until a day or so before the deadline.
The 14th Amendment and Discharge Petition look to be low probability remedies. In recent weeks the 14th Amendment, ratified as part of the U.S. Constitution in 1868, has been suggested as a means by which President Biden could disregard the legislative limit of the debt ceiling to move directly forward with interest and principal payments on U.S. Treasury bonds. This premise is based on a single sentence within Section 4 of the amendment stating that “The validity of the public debt of the United States, … shall not be questioned.” However, the degree to which this language would ultimately hold up in the courts as applied to the current debt ceiling, given its intent when originally written 155 years ago, is highly questionable. Another potential avenue — a House of Representatives Discharge Petition to bring a vote on the debt ceiling directly to the floor and bypassing party leadership — is also of low probability based not only on timing but the need for Democrats to convince a handful of Republicans to cross the aisle.
Given all of this, investors and the American public are now left with a “trust me” trade that the powers that be in our nation’s capital can either quickly come to an agreement or, if not, at least recognize the economically nuclear consequences of not doing so. This is a road both parties have been down before, albeit not to the magnitude of this time around. Logic and rationality dictate they will come together to prevent the worst-case scenario of a U.S. default, which both sides have stated is unacceptable. While such an outcome is still likely to play out in the days ahead, it is also probable both sides will fully consume the remaining time permitted, thereby potentially creating market volatility as well as a good bit of nervousness and angst among investors and hardworking citizens in the process.
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