With a deal on the US debt ceiling now having been agreed, a potentially ‘catastrophic’ default has been avoided. Moreover, unlike in 2011 when a last-minute agreement to increase the ceiling was secured, the US has, at least so far, avoided a downgrade of its credit rating (back then Standard & Poor’s downgraded the U.S. credit rating from AAA to AA+, where it has remained to this day). Against this backdrop, it would be easy to conclude that the whole affair was ‘much ado about nothing’. However, such a conclusion could prove premature, and there are several channels via which the recent debt ceiling debacle could impact the economic and financial market outlook during the coming months.
Modest fiscal tightening, rising debt
The agreement made between President Joe Biden and House Republican leader Kevin McCarthy, which suspends the nation’s US$31.4 trillion borrowing limit until January 2025, will result in some marginal tightening of fiscal policy. Although the spending cuts are not as big as Republicans originally wanted, non-defense spending will be more or less unchanged in fiscal year 2024 and rise by just 1% in 2025. When inflation is taken into account, this equates to a cut in real terms. According to the Congressional Budget Office (CBO), the Fiscal Responsibility Act (FRA), which implements the deal, will give rise to US$1.5 trillion of savings over a decade1.
Significantly, the modest fiscal tightening envisaged by the FRA fails to arrest the increase in the public debt burden during the coming years. According to the Congressional Budget Office, the FRA knocks three percentage points off the expected debt to GDP ratio in 10 years’ time, but this still rises to 115% by 2033, from 98% currently2. With debt servicing costs rocketing3 and the expectation that interest rates might have to stay higher for longer, there are upside risks to this forecast.
Given such a prospect, and with brinkmanship over the debt ceiling likely to return in less than two years’ time, the threat of a debt downgrade has not gone away completely. After the deal was agreed, the ratings agency Fitch said that its AAA rating for US government debt will remain on negative watch (meaning that its ability to pay its debt may be deteriorating) as “repeated political standoffs around the debt-limit…. lowers confidence in governance on fiscal and debt matters”4. Needless to say, a debt downgrade from one of the major agencies could usher in a period of market volatility, as was the case in 2011.
Growth impact
In terms of the impact on economic growth, the fallout from the debt ceiling deal appears to be slight. The consensus amongst economists seems to be that the FRA will knock 0.2-0.3 percentage points off GDP over 2023-25, and potentially reduce employment by up to 250,0005. This looks like small beer given that the US economy, which has so far proved more resilient than many observers expected at the start of the year, created 339,000 non-farm jobs in the month of May alone6.
However, the agreement will have a significant impact on the net incomes of some households and could weigh on consumer spending during the coming months. One of the deal’s provisions is the termination of forbearance on student loans, meaning that around 45 million borrowers who have not had to make student loan repayments since March 2020 (an initiative introduced as part of the government’s pandemic relief measures) will have to start paying again in September7.
Estimates from the Bureau of Economic Analysis (BEA) indicate that the pause on loan repayments reduced household interest payments by around US$38 billion per quarter while it was in effect8, while calculations from the Federal Reserve Bank of New York estimate the average monthly student loan payment is US$3939. Given that most individuals who have student loans are relatively young and therefore have a relatively high propensity to consume (i.e. they are more likely to spend any increase in income than save it), the resumption of repayments could result in a hit to consumer spending later this year.
Debt issuance surge
Increased debt issuance, as the Treasury seeks to rebuild its cash coffers, could also be a headwind for financial markets in the months to come. With the Treasury unable to issue new debt after the debt ceiling was hit in January of this year, the government has managed to maintain its spending over and above the revenue it generates from taxation by running down its bank account with the Federal Reserve (the US central bank), known as the Treasury General Account (TGA). According to data from the St. Louis Fed database the TGA balance fell from around US$410 billion at the end of last year to around US$49 billion at the end of May10.
This TGA rundown had the effect of adding liquidity to the financial system and the economy. This comes about because the government is effectively spending money without an offsetting increase in debt issuance or taxation. This is of potential significance for investors because many observers see a causal relationship between an increase in Fed liquidity (that has in part been facilitated by the TGA rundown and the recent support provided to troubled banks) and the run-up in US large cap equities that has been witnessed in recent months11. In very simplistic terms, the reasoning goes that if there is more cash sloshing around in the system, there is more money available to buy risk assets.
Some analysts see potential for this favourable liquidity effect to go into reverse, as the Treasury seeks to build back the balance on the TGA to more normal levels by issuing new debt. Indications are that the Treasury plans to raise the TGA balance to US$600 billion by the end of September 202312. Taking into consideration the fact that new debt issuance will also be required to pay back maturing debt and to fund the budget deficit (i.e. the shortfall between government spending and tax receipts), this will amount to a large amount of government paper coming to market. JP Morgan believe that net issuance of Treasury bills (i.e. short-term government debt) will be US$850 billion by end-September and US$1.1 trillion by end-202313.
This issuance comes at a time when the Fed is running down its holdings of bonds that were accumulated during earlier periods of Quantitative Easing (or QE), and while interest rate policy is becoming increasingly restrictive. At its June meeting, the Fed left its main policy interest at 5.0-5.25%, pausing the process of rate hikes in order to assess the impact of earlier monetary tightening, but signaled that it could raise rates by a further 50 basis points by the end of the year14.
Moreover, Fed Chair Jerome Powell indicated that the central bank would continue to reduce its holdings of bonds (so-called quantitative tightening, or QT) by allowing US$60 billion of government debt and US$35 billion of mortgage backed securities to mature without the proceeds being reinvested15.
These supply-demand dynamics represent a potential headwind for US bond markets and liquidity. Yields on US government debt have moved higher in recent weeks, as investors have braced for higher-for-longer interest rates and increased debt issuance16.
Liquidity drain?
The precise impact on liquidity and bank reserves in the financial system will depend on how the new debt issuance is absorbed. This issue is quite technical but could have a key bearing on financial market performance during the coming months. One potential source of demand for new government paper could be so-called Money Market Funds (MMFs, mutual funds that invest in short-term debt, such as US Treasury bills). If MMFs buy newly-issued bills by running down their balances at the Fed’s reverse repurchase facility (an arrangement whereby market participants lend cash to the Fed in exchange for US Treasuries), then the impact on reserves in the banking system, and liquidity, would be marginal. Under such circumstances, a reduction in the reverse repo balance could merely offset the increase in the TGA.
Alternatively, if investors purchase the newly-issued debt by running down cash balances in their bank accounts, then bank reserves will fall, reducing liquidity. It is important to remember here that the TGA rebuild will involve the proceeds from debt issuance sitting idly on account at the Fed, rather than being spent and therefore returning to the system.
Given the increasing focus on the role of liquidity in driving financial markets, investors will closely monitor the components of the Fed’s balance sheet during the weeks and months to come. Recent figures have shown a fall in the balance on the Fed’s reverse repo facility17, encouraging hopes that the impact of rising debt issuance on bank reserves and liquidity will be benign. Indeed, the benchmark equity index of the 500 largest US companies recently hit a 14-month high18 and measures of market volatility have fallen markedly19.
Nevertheless, the fact that heavy bond issuance during the coming months will occur against the backdrop of ongoing quantitative tightening from the Fed is a source of concern. Moreover, the expected hit to household spending from the restart of student loan repayments also comes at a time when leading indicators (such as the yield curve) point to an elevated risk of recession. In addition, Washington’s dysfunctional politics and an increasing debt burden suggest the threat of a ratings downgrade remains real. A debt ceiling crisis has been avoided in 2023, but the fallout from the aftermath could still be material.
20 June 2023
1 https://www.bbc.co.uk/news/world-us-canada-65744615
2 https://www.cbo.gov/publication/59260
3 https://fred.stlouisfed.org/series/A091RC1Q027SBEA
4 https://www.fitchratings.com/research/sovereigns/despite-debt-limit-agreement-us-aaa-rating-remains-on-negative-watch-02-06-2023
5 https://edition.cnn.com/2023/05/31/business/debt-deal-economic-effect
6 https://www.bls.gov/news.release/empsit.nr0.htm
7 https://time.com/6284294/debt-ceiling-student-loan-borrowers/
8 JP Morgan – Student loan payments to resume. 2nd June 2023
9 https://thecollegeinvestor.com/33643/average-student-loan-monthly-payment/
10 https://fred.stlouisfed.org/series/WDTGAL
11 https://www.marketwatch.com/story/this-incredible-chart-shows-the-close-relationship-between-the-s-p-500-and-fed-liquidity-166542a7
12 https://www.reuters.com/article/usa-treasury-cash/treasury-targets-425-bln-june-cash-balance-to-start-post-debt-ceiling-replenishment-idUSL1N37Z2HX
13 JP Morgan. Open the floodgates. 1st June 2023.
14 https://www.reuters.com/markets/rates-bonds/view-still-hawkish-fed-pauses-rate-tightening-after-10-straight-hikes-2023-06-14/
15 https://www.reuters.com/markets/us/feds-powell-appears-see-plenty-room-run-balance-sheet-drawdown-2023-06-14/
16 https://tradingeconomics.com/united-states/2-year-note-yield
17 https://fred.stlouisfed.org/series/RRPONTSYD
18 https://fred.stlouisfed.org/series/SP500
19 https://fred.stlouisfed.org/series/VIXCLS