US debt ceiling: Overcooked milk doesn't smell good
By Volker Schmidt, Senior Portfolio Manager at Ethenea
The markets seem to have seen the dance around the debt pot so many times that it has become something of a ritual in Washington.
If you boil milk in a pot with a lid on, you run the risk of it boiling over quickly. In the US, the ultimate cookbook, the state constitution, says that the (debt) lid must always be on. So, the cooks in the US state legislatures must always be careful not to boil the pot with their annual debt resolutions. One alternative is to lift the lid on the pot. This has been done 79 times in US history, and more than ten times since 2010. In the duel between the two kitchen teams, the Democrats and the Republicans, with their cooks, President Biden and House Speaker McCarthy, the Democrats are in favour of raising the lid, while the Republicans would rather not see so much milk.
After US Treasury Secretary Janet L. Yellen warned leaders of both houses of Congress on 19 January that the current debt ceiling of about $31.4 trillion would be reached that day and that the world's largest bond issuer would face illiquidity in summer without swift action, chefs were concerned. As any chef knows, when the milk starts to boil, you need to act fast. The "extraordinary measures" Yellen referred to in her letter gave policymakers until August 2023.
Although the American financial kitchen is even more difficult to navigate than its TV counterpart MasterChef, 2011 will be remembered by market participants mainly as an example of the hard-fought battle over the debt ceiling. The impact on consumers and investors was clearly felt in 2011. Consumer and business confidence fell sharply, the S&P 500 stock index lost 17% in the two weeks around the deadline, while stock price volatility and credit spreads rose sharply and stayed high for a long time. Yields on Treasury securities and other money market instruments maturing around the deadline fell particularly sharply at times, while some Treasury securities were no longer accepted as collateral for derivatives transactions. The increased risk of default dampened foreign investors' demand for short-term US government bonds, and the Dollar depreciated by 9.2% against the Euro from the beginning of 2011 until the problem was resolved.
Current market reaction
The closer we get to the so-called X date, the day the US defaults, the more likely it is that, as in 2011, the cooks will watch until the last day as the white liquid in the pot boils over. Recently, Treasury Secretary Yellen warned that the government could run out of liquidity and borrowing capacity as early as 1 June. This is about two months earlier than expected and is due to weaker tax revenues. As inflows and outflows in the General Treasury Account, the main account of the US Treasury, are very volatile, it is difficult to calculate the exact date.
However, the markets seem to have a much better idea of the date. Money market funds buy short-term US Treasuries maturing before the possible date, driving up prices. Treasury bills maturing in early June, on the other hand, are so shunned that there is an unnatural jump in yields between maturities that are only a few days apart.
The credit default swap (CDS) market is already pricing in a very high risk of a repeat of 2011. CDS spreads, which reflect the cost of insuring US debt, have already doubled since 2011.
The US stock market, on the other hand, does not appear to be panicking. Consumers are also relaxed and continue to spend despite the upcoming political battles. Even the Dollar has been little changed recently and shows no signs of weakness. The stock and currency markets seem to have seen the dance around the debt pot so many times that it has become something a ritual in Washington.
However, the political climate in the US is now more polarised than ever, and the hostile atmosphere in Congress could make it difficult to find a solution to the debt ceiling. Many supporters of both kitchen teams seem unwilling to compromise, and some would rather see the country go bankrupt than give in to negotiations. You can't like Donald Trump, but what you can't deny is his popularity with Republican voters. The former US president recently urged Republican lawmakers to let the US default on its debt if Democrats do not agree to spending cuts.
There is still time for Congress to resolve its political differences and, as history has shown, American politicians are more inclined to bury the hatchet sooner or later and avoid the doomsday scenario mentioned above, when the entire country is threatened with insolvency. The consequences would be more than unpleasant. Like in the kitchen after the milk has spilled, Americans will have to deal with the acrid stench of a lowered credit rating. And cleaning up the mess is usually very expensive. Hardly anyone wants to see how low the markets will sink after the US default. When the milk has reached the edge of the pot, it is better to lift the lid.
