U.S. financial conditions remain a drag on overall economic activity.
Our composite RSM US Financial Conditions Index remained at 0.9 standard deviations below neutral on Friday, corresponding to higher levels of risk than would normally be priced into securities.
As investors await a resolution of the debt ceiling standoff, risk aversion is likely to define global and U.S. financial markets.
Through May 19, the Treasury’s cash on hand stood at $60.5 billion, down from $866.7 billion a year ago.
Even though money market spreads have been neutral and the equity markets have continued their recovery, the Treasury yield curve continues to price in a recession while the high-yield bond market is similarly pricing in greater risk.
State of play: The debt ceiling
Despite the noise surrounding the debate, we think that a framework for a last-minute agreement is in place.
This framework includes the return of the roughly $56 billion in unspent pandemic-era money to Congress, reforms to allow faster permitting of energy infrastructure projects and a restraint on discretionary outlays over the next two years.
To be clear, any limits on spending would not affect aid to needy families or unemployment insurance if the economy falls into recession over the next two years. All parties should anticipate Congress moving to increase such outlays if a downturn happens.
Asset volatility ahead
Despite distortions at the front end of the yield curve that are creating headaches for the corporate sector and the rising cost of credit default swaps, the public will probably not understand the risk around the debt ceiling debate until it affects their retirement portfolios.
But a fall in equity prices, despite recent gains, will happen if negotiations break down. For example, at the outset of the debt ceiling crisis in 2011, the S&P 500 lost 17% over 11 weekdays. It then took seven months to recoup those losses. Even a delay in raising the debt ceiling is likely to cause equity-market losses.
Distortions in the money markets
Already, the threat of default has cooled commercial lending and upset the money markets that finance day-to-day business operations like meeting a payroll.
Business lending has tightened as borrowers and lenders grow skeptical about the prospects of the economy and the increased likelihood of business and personal bankruptcy. Those conditions would only worsen should there be a default or a delay of government payments.
In the money markets, the yield on the one-month T-bill plunged as the demand for the safety of short-term securities increased during March and April.
When expectations of the X-date, or the date when default will take place, moved back to early June, the one-month rate moved abnormally higher than the three-month and six-month rates as the markets priced in additional risk of holding even the shortest of securities.
In addition, T-bill rates increased as talks broke down over the past week.
The cost of this rising risk will fall on businesses as the higher cost of credit reduces profits and dampens household demand.
Increased cost of capital
Finally, there is the cost of issuing dollar-denominated debt. Because of the frequent threats of default over the years, the United States is now ranked second to Germany in debt quality. U.S. taxpayers bear the cost of the lower ranking.
We can see this higher cost during recent episodes. When perceptions of the U.S. government defaulting have risen, the cost of insuring against default on dollar-denominated debt has spiked.
In the credit default swap market, the cost of insuring against default within the next year is now double what it was during the financial crisis.
One-year dollar-based swaps have been trading within a range of 155 to 175 basis points. Although the swaps fell to 125 during the negotiations on Friday, they remain significantly higher than the 15 basis points during normal times and the 90 basis points at the worst of this year’s banking turmoil.
Unintended consequences
Each of the policy shocks of the past 15 years has resulted in tightened financial conditions and a reduced propensity to borrow and lend.
In simpler terms, the loss of confidence in our institutions creates the conditions for slower growth. And although none of these incidents has caused an outright recession, stumbling from one crisis to another creates an economy unwilling to invest in itself and restrains growth.
Failure to raise the debt ceiling would call into question the trustworthiness of the U.S. government, and would raise the interest rate on future debt offerings.
The cost all goes back to taxpayers. The Congressional Budget Office in 2011 reported that an increase of a tenth of a percentage point in Treasury rates would cost $130 billion over the next decade.
Now, a default would translate into roughly $50 billion in higher interest rate payments next year and more than $750 billion over the next decade, according to an analysis published by the Brookings Institution. That is a significant cost to the public and an unnecessary misdirection of funds.
There will be other unintended consequences that the general public will undoubtedly miss. For example, the rush of debt issuance when the debt ceiling is ultimately lifted will suddenly push up the supply of short-term Treasury bills.
That action will draw money out of the private sector, increasing the cash held by the Treasury to an estimated $550 billion from the current level of about $95 billion before hitting $600 billion three months later, according to a Bloomberg analysis.
That shift will drain funds otherwise available to the equity market or to credit markets that finance the business community. The result will be a falling stock market, reduced income and a slowing economy.
Policy considerations
The question, then, is how to get around the standoff.
While the use of the discharge rules to force a vote on the floor of the House remains a possibility, the rules of the House make that unlikely to happen before June 7. And its history suggests a low probability of passing a full vote.
Some observers have proposed that the Treasury create a trillion-dollar coin and send it to the Federal Reserve to pay for government expenses. We do not consider this to be a serious idea worthy of consideration.
There is also the argument that the Biden administration invoke the 14th Amendment and overrule efforts to allow the default to occur.
We contend that the existence of the debt ceiling is antithetical to the separation of powers between the legislative branch and the executive branch and should be eliminated.
The legislature is given the role of taxing and spending, while the Treasury is tasked with financing and spending those monies. But such a move to invoke the 14th Amendment would cause significant volatility and hurt financial markets and the economy until that decision can be adjudicated by the courts.
That leaves negotiators going back to their traditional roles and reaching an equitable compromise along the lines of what we have outlined. Without one, the risks to financial markets and the economy will only rise.
