Some people create their own storms. And then get upset when it starts to rain. US Debt Ceiling drama is akin to a soap opera that never ends.
Debt ceiling issue is not new. Why bother now? Political polarisation in the US has got to unprecedented levels. The showmanship could tip over into a political nightmare. It could send economic shockwaves with impact deeply felt both within US and well beyond its shores.
Many politicians seemingly are so pulled away from reality that their fantasies aren’t working. Wishing away a problem out of its existence is not a solution.
The Debt Ceiling is here. US defaulting on its debt is highly unlikely. Scarily though, the probability of that occurrence is non-zero.
This paper looks at recent financial history surrounding prior debt ceiling episodes. Crucially, it delves into investor behaviour and their corresponding investment decisions across various asset classes.
When uncertainty looms large, straddles and spreads arguably deliver optimal hedging and investment outcomes.
A SHORT HISTORY OF DEBT CEILING. WHAT IS IT? HAS IT BEEN BREACHED BEFORE?
The US debt ceiling is a maximum cap set by the Congress on the debt level that can be issued by the US Treasury to fund US Government spending.
The ceiling was first introduced in 1917 to give US Treasury more flexibility to borrow money to fund first world war.
When the US government spends more money than it brings in through taxes and revenues, the US Treasury issues bonds to make up the deficit. The net treasury bond issuance is the US national debt.
Last year, the US Government spent USD 6.27 trillion while only collecting USD 4.9 trillion in revenue. This resulted in a deficit of “only” USD 1.38 trillion which had to be financed through US treasury bond issuance.
This deficit was not an exception. In fact, that’s the norm. The US Government can afford to and has been a profligate borrower. It has run a deficit each year since 2001. In fact, it has had budget surplus ONLY five (5) times in the last fifty (50) years.
If that wasn’t enough, the deficit ballooned drastically from under USD 1 trillion in 2019 to more than USD 3.1 trillion in 2020 and USD 2.7 trillion in 2021 thanks to massive pandemic stimulus programs and tax deferrals.
This pushed the total US national debt to a staggering USD 31.46 trillion, higher than the debt ceiling of USD 31.4 trillion.
The limit was breached! So, what happened when the ceiling was broken?
Not that much actually. When the ceiling is broken into, the US Congress must pass legislation to raise or suspend the ceiling. Congress has raised the ceiling not once but 78 times since 1970.
The decision is usually cross-partisan as the ceiling has been raised under both Republicans and Democrats. It was last raised in 2021 by USD 2.5 trillion to its current level.
Where consensus over raising the ceiling cannot be reached, Congress can also choose to suspend the ceiling as a temporary measure. This was last done from 2019 to 2021.
Since January, the Treasury has had to rely on the Treasury General Account and extraordinary measures to keep the country functioning.
Cash balance at the Treasury remains precariously low. Its operating balance stood close to nearly USD 1 trillion last April but now hovers around USD 200 billion.
Such reckless borrowing! Yet US continues to remain profligate. How?
Global investors have confidence in the US Government's ability to service its debt. Despite the increasing debt, the US Government continues to pay investors interest on its bonds without a miss.
Strong economic growth and its role as a global economic powerhouse assuages investor concerns over a potential default.
Additionally, where Treasury does not have adequate operating cash flow, it leans on a credit line from the Federal Reserve (“Fed”). The dollar’s strength and reserve status contribute to the US Government’s creditworthiness and vice-versa.
The Fed is also the largest holder of US government debt. It holds USD 6.1 trillion as of September 2022 (20% of the overall debt). The share of government debt held by the Fed surged to current levels from just above 10% during the pandemic due to massive purchases of treasury bills by the Fed as an emergency stimulus measure.
GROWING US DEBT IS BECOMING A SOURCE OF CONCERN
US debt has ballooned during the pandemic. It is deeply concerning for multiple reasons. Key among them is the risk of default. Although debt has increased significantly, GDP growth during this period has been tepid due to pandemic restrictions stifling economic activity.
As such the ratio of national debt to GDP, a measure of the US’s ability to pay back its loan has also skyrocketed. This increases the risk that the US Government may fail to service its debt.
A US Government default would lead to surging yields on treasury bonds and crashing stock prices. It would also call into question its creditworthiness limiting future borrowing potential.
A default will also have far-reaching economic consequences threatening dollar hegemony which is already being challenged on multiple fronts.
Another concern is the rising cost of servicing the debt. Servicing the debt is the single largest government expense. Interest payments on debt this year are expected to reach USD 357.1 billion or 6.8% of all government expenditure.
Additionally, with the Fed having raised interest rates with no stated intention of pivoting in 2023, the interest rate on US public debt, which is currently at historical lows, will also rise.
DEBT CEILING BREACH AGAIN. SO WHAT? LOOKING BACK IN TIME FOR ANSWERS.
There has been more than one occasion when political disagreements resulted in Congress delaying the raising of the debt limit.
In 2011, political disagreements pushed the government to the brink of default. The ceiling was raised just two (2) days before the estimated default deadline (the “X-date”).
Despite the raise, S&P lowered its credit rating for the United States from AAA to AA+ reflecting the effects that political disagreements were having on the country’s creditworthiness.
This played out again in 2013 due to same political disagreements. Thankfully, for investors, the effects of the 2013 crisis on financial markets were not as severe.
Flash back. Equity markets initially dropped after the debt ceiling was reached and investors worried that the disagreements would not be resolved in time. In July 2011, markets started to recover as both parties started to work on deficit reduction proposals.
Then on July 25th, just eight (8) days before the borrowing authority of the US would be exhausted, Credit Default Swaps on US debt spiked and the CDS curve inverted as participants feared that a deal would not be reached in time. This led equities sharply lower.
On August 2nd, a bill raising the ceiling was rushed through both the House and the Senate. Following this S&P lowered US credit rating from AAA to AA+ citing uncontrolled debt growth. Equity prices continued to drop even after the passage of the bill.
Commodities showed similar price behaviour heading into the passage of the bill. However, unlike stocks, gold and silver prices rallied after August 2nd.
The USD weakened against other currencies before the passing of the bill but recovered after August 2nd.
Treasury yields trended lower but spiked during key events during this period. Short-term treasury yields remained highly volatile. Following crisis resolution, yields plunged sharply.
US DEBT CEILING CRISIS AGAIN. WHAT NOW IN 2023?
The US reached its debt ceiling again in January 2023 and yet another debt crisis. 2013 is repeating itself again as lawmakers disagree over whether to raise the ceiling further or bring the budget under control.
The Congressional Budget Office (CBO), a non-partisan organization, has estimated that the US could be at a risk of default as early as June 1st.
Republicans disagree with the Biden administration. They seek budget cuts to reduce annual deficits while Democrats want the ceiling to be raised without any conditions tied to it.
This crisis is exacerbated by rising political polarisation in the US. Not just metamorphically, the Republicans and Democrats are at each other’s throat.
A study by the Carnegie Endowment for International Peace found that no established democracy in the recent past has been as polarised as the US is today. This raises the risk that Congress gets into a stalemate.
Moreover, the house is only in session for 12 days in May. After the law is passed in Congress it must also pass through the Senate and the President. The availability of all three overlap on just seven (7) days, the last of which is the 17th of May. This means that lawmakers have just 3 days (from May 12th) to reconcile their differences before the US is put at risk of default.
POSITIONING INVESTMENT PORTFOLIOS IN DEBT CRISIS WITH X-DATE IN SIGHT
What’s X-date? It refers to the date on which the US Government would have exhausted all its options except debt default.
The X-date could arrive as early as June 1st. There is a small chance that it could arrive in late July or early August. The US Government collects tax receipts in mid-June. If the US Treasury can stretch until then it will have enough cash to last another six weeks before knocking against the debt ceiling again.
The current crisis has been brewing. Equity markets remain sanguine. But near-term treasury yields have started panicking. Short term yields have spiked. The difference in yield on Treasury Bills that mature before the likely X-date (23/May) & after it (13/June) has shot up.
Muted equity markets create compelling opportunity for short sellers. In the same vein, it also presents buying opportunities when debt ceiling is eventually lifted.
When up or down is near impossible to predict, an astutely crafted straddle or time spread can save the day.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Debt ceiling issue is not new. Why bother now? Political polarisation in the US has got to unprecedented levels. The showmanship could tip over into a political nightmare. It could send economic shockwaves with impact deeply felt both within US and well beyond its shores.
Many politicians seemingly are so pulled away from reality that their fantasies aren’t working. Wishing away a problem out of its existence is not a solution.
The Debt Ceiling is here. US defaulting on its debt is highly unlikely. Scarily though, the probability of that occurrence is non-zero.
This paper looks at recent financial history surrounding prior debt ceiling episodes. Crucially, it delves into investor behaviour and their corresponding investment decisions across various asset classes.
When uncertainty looms large, straddles and spreads arguably deliver optimal hedging and investment outcomes.
A SHORT HISTORY OF DEBT CEILING. WHAT IS IT? HAS IT BEEN BREACHED BEFORE?
The US debt ceiling is a maximum cap set by the Congress on the debt level that can be issued by the US Treasury to fund US Government spending.
The ceiling was first introduced in 1917 to give US Treasury more flexibility to borrow money to fund first world war.
When the US government spends more money than it brings in through taxes and revenues, the US Treasury issues bonds to make up the deficit. The net treasury bond issuance is the US national debt.
Last year, the US Government spent USD 6.27 trillion while only collecting USD 4.9 trillion in revenue. This resulted in a deficit of “only” USD 1.38 trillion which had to be financed through US treasury bond issuance.
This deficit was not an exception. In fact, that’s the norm. The US Government can afford to and has been a profligate borrower. It has run a deficit each year since 2001. In fact, it has had budget surplus ONLY five (5) times in the last fifty (50) years.
If that wasn’t enough, the deficit ballooned drastically from under USD 1 trillion in 2019 to more than USD 3.1 trillion in 2020 and USD 2.7 trillion in 2021 thanks to massive pandemic stimulus programs and tax deferrals.
This pushed the total US national debt to a staggering USD 31.46 trillion, higher than the debt ceiling of USD 31.4 trillion.
The limit was breached! So, what happened when the ceiling was broken?
Not that much actually. When the ceiling is broken into, the US Congress must pass legislation to raise or suspend the ceiling. Congress has raised the ceiling not once but 78 times since 1970.
The decision is usually cross-partisan as the ceiling has been raised under both Republicans and Democrats. It was last raised in 2021 by USD 2.5 trillion to its current level.
Where consensus over raising the ceiling cannot be reached, Congress can also choose to suspend the ceiling as a temporary measure. This was last done from 2019 to 2021.
Since January, the Treasury has had to rely on the Treasury General Account and extraordinary measures to keep the country functioning.
Cash balance at the Treasury remains precariously low. Its operating balance stood close to nearly USD 1 trillion last April but now hovers around USD 200 billion.
Such reckless borrowing! Yet US continues to remain profligate. How?
Global investors have confidence in the US Government's ability to service its debt. Despite the increasing debt, the US Government continues to pay investors interest on its bonds without a miss.
Strong economic growth and its role as a global economic powerhouse assuages investor concerns over a potential default.
Additionally, where Treasury does not have adequate operating cash flow, it leans on a credit line from the Federal Reserve (“Fed”). The dollar’s strength and reserve status contribute to the US Government’s creditworthiness and vice-versa.
The Fed is also the largest holder of US government debt. It holds USD 6.1 trillion as of September 2022 (20% of the overall debt). The share of government debt held by the Fed surged to current levels from just above 10% during the pandemic due to massive purchases of treasury bills by the Fed as an emergency stimulus measure.
GROWING US DEBT IS BECOMING A SOURCE OF CONCERN
US debt has ballooned during the pandemic. It is deeply concerning for multiple reasons. Key among them is the risk of default. Although debt has increased significantly, GDP growth during this period has been tepid due to pandemic restrictions stifling economic activity.
As such the ratio of national debt to GDP, a measure of the US’s ability to pay back its loan has also skyrocketed. This increases the risk that the US Government may fail to service its debt.
A US Government default would lead to surging yields on treasury bonds and crashing stock prices. It would also call into question its creditworthiness limiting future borrowing potential.
A default will also have far-reaching economic consequences threatening dollar hegemony which is already being challenged on multiple fronts.
Another concern is the rising cost of servicing the debt. Servicing the debt is the single largest government expense. Interest payments on debt this year are expected to reach USD 357.1 billion or 6.8% of all government expenditure.
Additionally, with the Fed having raised interest rates with no stated intention of pivoting in 2023, the interest rate on US public debt, which is currently at historical lows, will also rise.
DEBT CEILING BREACH AGAIN. SO WHAT? LOOKING BACK IN TIME FOR ANSWERS.
There has been more than one occasion when political disagreements resulted in Congress delaying the raising of the debt limit.
In 2011, political disagreements pushed the government to the brink of default. The ceiling was raised just two (2) days before the estimated default deadline (the “X-date”).
Despite the raise, S&P lowered its credit rating for the United States from AAA to AA+ reflecting the effects that political disagreements were having on the country’s creditworthiness.
This played out again in 2013 due to same political disagreements. Thankfully, for investors, the effects of the 2013 crisis on financial markets were not as severe.
Flash back. Equity markets initially dropped after the debt ceiling was reached and investors worried that the disagreements would not be resolved in time. In July 2011, markets started to recover as both parties started to work on deficit reduction proposals.
Then on July 25th, just eight (8) days before the borrowing authority of the US would be exhausted, Credit Default Swaps on US debt spiked and the CDS curve inverted as participants feared that a deal would not be reached in time. This led equities sharply lower.
On August 2nd, a bill raising the ceiling was rushed through both the House and the Senate. Following this S&P lowered US credit rating from AAA to AA+ citing uncontrolled debt growth. Equity prices continued to drop even after the passage of the bill.
Commodities showed similar price behaviour heading into the passage of the bill. However, unlike stocks, gold and silver prices rallied after August 2nd.
The USD weakened against other currencies before the passing of the bill but recovered after August 2nd.
Treasury yields trended lower but spiked during key events during this period. Short-term treasury yields remained highly volatile. Following crisis resolution, yields plunged sharply.
US DEBT CEILING CRISIS AGAIN. WHAT NOW IN 2023?
The US reached its debt ceiling again in January 2023 and yet another debt crisis. 2013 is repeating itself again as lawmakers disagree over whether to raise the ceiling further or bring the budget under control.
The Congressional Budget Office (CBO), a non-partisan organization, has estimated that the US could be at a risk of default as early as June 1st.
Republicans disagree with the Biden administration. They seek budget cuts to reduce annual deficits while Democrats want the ceiling to be raised without any conditions tied to it.
This crisis is exacerbated by rising political polarisation in the US. Not just metamorphically, the Republicans and Democrats are at each other’s throat.
A study by the Carnegie Endowment for International Peace found that no established democracy in the recent past has been as polarised as the US is today. This raises the risk that Congress gets into a stalemate.
Moreover, the house is only in session for 12 days in May. After the law is passed in Congress it must also pass through the Senate and the President. The availability of all three overlap on just seven (7) days, the last of which is the 17th of May. This means that lawmakers have just 3 days (from May 12th) to reconcile their differences before the US is put at risk of default.
POSITIONING INVESTMENT PORTFOLIOS IN DEBT CRISIS WITH X-DATE IN SIGHT
What’s X-date? It refers to the date on which the US Government would have exhausted all its options except debt default.
The X-date could arrive as early as June 1st. There is a small chance that it could arrive in late July or early August. The US Government collects tax receipts in mid-June. If the US Treasury can stretch until then it will have enough cash to last another six weeks before knocking against the debt ceiling again.
The current crisis has been brewing. Equity markets remain sanguine. But near-term treasury yields have started panicking. Short term yields have spiked. The difference in yield on Treasury Bills that mature before the likely X-date (23/May) & after it (13/June) has shot up.
Muted equity markets create compelling opportunity for short sellers. In the same vein, it also presents buying opportunities when debt ceiling is eventually lifted.
When up or down is near impossible to predict, an astutely crafted straddle or time spread can save the day.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
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