Even though there is no technical link between the two main fiscal issues – the continuing resolution (CR) and the debt ceiling bill – there is a link in the minds of market participants because prompt resolution of the CR could spell a favorable outcome for the debt limit. On the other hand, a government shutdown tonight could lead the market to be more pessimistic on the chances of a debt default. As BofAML notes, the link between the two issues is fairly complex but the shutdown battle is just the beginning – and, as they suspect “the fight could get ugly.”
As BofAML notes,
In Washington, the link is viewed differently, with the House Republican leadership seeing an immediate deal on the CR leaving more negotiating room on the debt limit, but a shutdown having an immediate negative political impact and increasing the chances of a political capitulation on the debt limit. The link between the two issues is fairly complex.
Debt ceiling – paying the bills
The shutdown battle is just the beginning. At the time of this writing, the House decided to delay any action on an initial version of the debt limit extension, with numerous extraneous provisions attached, including a one-year delay in implementing the ACA, the Keystone pipeline, energy policy, financial regulation, and others. These extra provisions could be a basis for giving the Republicans some political cover in passing a debt limit extension.
However, disagreements among House Republicans have delayed this initial vote on the debt limit for at least several days. The president continues to insist there will be no negotiations over the debt limit. The divisions among House Republicans, as well as the relative political weakness of the president, who has seen his approval ratings decline, increase the difficulty of finding a path that would lead to a solution. We expect a solution will be reached before the deadline because the political costs of a debt default would be significant.
Important dates, mechanism of debt ceiling raise
The deadline dates pertinent to the debt limit have been narrowed considerably. The Treasury released an estimate that extraordinary accounting maneuvers allowing public debt issuance at the debt limit would be exhausted by October 17, at the latest. The CBO also estimated that the cash balance would be run down sometime between October 22 and the end of the month. In our view, there are three relevant dates, using our estimates of the path of the debt outstanding subject to the limit and the Treasury cash balance.
We estimate that the Treasury exhausts its accounting maneuvers on October 15. This date is the settlement of the mid-month coupon auctions, in the 3y, 10y, and 30y maturities. Any uncertainty in the ability to settle the entire auction without breaching the debt limit would require one of three choices:
- delaying the auctions and issuing cash management bills instead,
- scaling down the auction sizes to only roll over maturing issues,
- or auctioning the full amount and scaling down the regular bill sizes ahead of time to create enough headroom,
with the last alternative being the most likely in our view. According to our estimates, this date would be a fairly close call, but maneuvers are certain to be exhausted in the next day or so, with a mid-October payment into the Highway Trust Fund.
After this date, the Treasury would be in rollover mode, issuing just enough at each auction to roll over maturing debt, while paying for outlays using withholding tax revenues and steadily draining the outstanding cash balance. In our view the Treasury may have enough cash balance to make it to the end of the month and make the month-end interest payment, although there is substantial uncertainty.
Treasury will fail on its scheduled spending obligations on November 1, having almost certainly exhausted its cash balance. A total of $67bn in payments for social security, Medicare, Medicaid, military pay, and veterans programs will be due on this date. After this, the Treasury could only spend money as it comes in via tax revenues, with scheduled payments being delayed or only paid partially. It is uncertain how the Treasury will prioritize spending programs.
The first large coupon interest payment of $31bn is paid on November 15. If the debt limit is not raised by then, the Treasury is likely to fail to pay bond interest and will be in technical default.
There are four key factors while analyzing possible market implications of the upcoming fiscal debates, in our view.
Higher market sensitivity to fiscal discussions: Given that both Chairman Bernanke (in his September FOMC press conference) and NY Fed President Dudley referred to the upcoming discussions as a risk factor for their outlook, market sensitivity to these headlines is likely to be more than initially anticipated. Tapering expectations priced into the market may change depending on the severity of the outcome.
The fight could get ugly: As our economics team points out, by shifting the focus of the debate to the funding of the ACA (instead of specific spending cuts), the Republicans have found a less politically dangerous strategy. At the same time, President Obama perceives himself in a stronger negotiating position given that he does not face reelection this time, reducing the effect of some of his own declining approval polling numbers and other recent polls that show equal blame adhering to both sides in a shutdown.
The result is unlikely to be near-term fiscal tightening: Given the gradually improving deficits over the last few years, the discussions on the current episode are unlikely to result in near-term fiscal tightening (unlike 2011, which led to the sequester). This is evident in that most Republican proposals no longer attach near-term cuts to spending. Instead, they are focused on health care and entitlement spending.
External factors that affected us in 2011 unlikely to repeat: This episode is unlikely to be of the same scale as the debt ceiling crisis in 2011. At that time, economic data were very weak, the Fed strengthened its forward guidance and was contemplating Operation Twist, European peripheral spreads were widening dramatically, and there was novelty around the debt ceiling and possible downgrades of the US sovereign credit rating. None of these one-time factors are in play this time.
Even though there is no technical link between the two issues, there is still a link in the minds of market participants because a government shutdown next week may lead the market to be more pessimistic on the chances of a debt default.
While comparing the market reactions from 2011, we caution investors to be aware of certain key differences. There was a novelty to dealing with the ceiling in 2011. The US in recent history had not experienced such a bitter showdown on whether to pay the nation’s bills, and markets likely had greater uncertainty premiums.