A busy summer on the fiscal front in Washington that’s seen progress on budget and infrastructure legislation could soon give way to another showdown over the U.S. statutory debt ceiling, potentially signaling volatility for investors in the months ahead.
The Senate recently passed a $550 billion bipartisan infrastructure bill and a $3.5 trillion non-binding budget before leaving town for its August recess. That was followed by the House passing the budget and scheduling a vote on the bipartisan infrastructure bill by the end of September.
The passage of the budget marks the first step in the reconciliation process, which should ultimately allow the Senate to circumvent the filibuster rules and consider a “soft infrastructure” bill with only 50 votes, rather than the usual 60, probably later this year after several noisy months of negotiations.
Regardless, as we have pointed out (see our July blog post, “We Have a Deal”), we believe the subsequent, Democratic-only bill will be considerably smaller than the $3.5 trillion price tag headlined in the budget and will ultimately be whittled down to about $2 trillion of new spending over 10 years, and paid for by tax increases, which will also be watered down relative to what has been proposed.
Nevertheless, we do not believe failure is an option for Democrats – especially given the recent fallout from the withdrawal of U.S. troops in Afghanistan – and we expect both bills to ultimately pass by the end of the year. Although we expect both fiscal packages to have a positive growth impact over the longer term, we anticipate the effect on GDP to be relatively de minimis for 2022.
And yet, the market has started to focus on another upcoming fiscal inflection point: the U.S. debt ceiling, which is the limit on how much debt the U.S. can issue to pay for previous and future spending.
Having been suspended until 31 July 2021 in August 2019, the debt ceiling will need to be raised in October or November, when the U.S. Treasury will likely run out of its “extraordinary measures” to fund government activities. Although the conventional wisdom is that, of course, Congress will raise the debt ceiling – failing to do so would be nearly unthinkable and would hurt Democrats politically – the strategy to do so remains murky at best, which may roil financial markets and could increase the chances of a policy mistake.
A distinction without a difference?
There are theoretically two ways for Democrats, who control Congress, to address the debt ceiling. They could insert an outright ceiling increase in the Democrat-only soft infrastructure bill, which would require only 50 votes, or pass a suspension for a certain period of time, which requires 60 votes.
While this may seem like a distinction without a difference, it is important for many moderate Democrats who would prefer to suspend the debt ceiling rather than be attacked for increasing it by a certain amount (which would be in the trillions). For this reason, it appears that Democrats are preparing to pursue a suspension, which would require at least 10 Republican votes to pass in the Senate.
The complication is that 46 of the 50 Senate Republicans have indicated they will not vote for any sort of increase, raising the odds of a debt ceiling showdown and potentially causing an unforced error for Democrats.
A hectic September?
At this point, we believe the most plausible way forward is that Democrats try to attach a debt ceiling suspension to a fiscal year-end (30 September) funding bill, which needs to pass to avoid a government shutdown, and effectively dare Republicans to vote against it. Depending on how it plays out, we could see Congress shut down the government before ultimately coming to a deal on the ceiling, similar to what happened in October 2013. As it did then, a shutdown could create volatility in financial markets and potentially affect the calculus of the Federal Reserve’s timing on tapering its asset purchases.
Markets: all clear?
Markets have so far appeared sanguine about the outlook for avoiding a disruptive debt ceiling event this fall. However, one lesson from previous episodes is that markets cannot be relied upon as an early warning indicator.
During President Barack Obama’s tenure, there were three debt ceiling showdowns that nearly resulted in the U.S. Treasury being unable to pay its commitments. One focal point of stress during these three episodes was the market for U.S. Treasury bills, due to its size and ease of facilitating U.S. government financing needs. In each case, T-bill yields did not move higher – to price a greater likelihood of default – until about one week before the so-called X date, the drop-dead date when the Treasury would run out of its funding capacity under the ceiling and begin to prioritize payments due in an effort to avoid a breach of the prescribed debt limit.
Fed facility may change dynamics
The market implications of a binding debt ceiling are complicated. Because the Treasury would have to reduce cash balances as the ceiling approaches, it would likely draw down bills. That declining supply could cause bill yields to fall – a counterintuitive move. A flight to safety into bills resulting from broader market risk aversion could further push down yields.
Still, bill yields have a key floor this time – and T-bill purchasers have an appealing alternative – in the Fed’s reverse repo facility, which the central bank is using to help conduct monetary policy by providing money market funds a safe place to invest excess cash. Although this is a good thing for the T-bill market, it may not be so good for the Treasury. Under a prolonged debt ceiling standoff, investors en masse could move their exposure to the Fed, creating run-risk dynamics.
In any event, usage of the reverse repo facility will likely continue to grow beyond the current size of about $1 trillion.
As the debt ceiling draws near, it could raise questions not only about the Treasury’s ability to roll over bills that mature near the X date, but also its capacity to make coupon payments around that time. That could lead to volatility in over $4.7 trillion of Treasury securities outstanding with coupon payments due in late October and mid-November. The Treasury will owe about $40 billion in interest payments mid-November to the holders of these securities.
Although resolution has come at a late hour in prior episodes, in our view it would be a mistake for investors to assume that there would not be major market ramifications if Congress failed to address the debt ceiling this time around. As we observed in both September 2019 and March 2020, funding-market liquidity is critical for market functioning, and the perceived safety of U.S. government debt is the bedrock for funding markets.
Therefore, it is important not to misinterpret the calm and patience exemplified in current market conditions as a state of diminished risks. Instead, investors should keep an eye out for pockets of volatility as we head toward the end of 2021.
For more insights into U.S. public policy, please read “We Have a Deal: U.S. Infrastructure Spending Soon, Tax Increases Likely Later.”
test is PIMCO’s head of public policy. Jerome Schneider is a managing director and leads short-term portfolio management at PIMCO. Jerry Woytash is a portfolio manager on the short-term desk.
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