In mid-January 2023, Treasury Secretary Janet Yellen sent a letter to Congress stating that the US would hit its debt limit of just under $31.4 trillion on January 19. She went on to say that Treasury would begin employing “extraordinary measures” in order to remain current on its outstanding obligations.

House Republicans are vowing to use the debt ceiling debate to force budget cuts on the Biden administration – and the White House is refusing to play ball. So how exactly does this all work?

Debt Ceiling 101 and Extraordinary Measures
Congress is in charge of determining the limit on US debt. Suspending or raising the debt ceiling requires approval from both the House of Representatives and the Senate.
  • It takes 218 votes to pass in the House and 60 votes to pass in the Senate.
  • House Republicans will likely get those 218 votes, but the 60 in the Senate? Highly unlikely.
In the meantime, the country’s bills must be paid. So exactly how “extraordinary” are the measures Treasury needs to take? They’ve actually been used more than a dozen times since the mid-1990s – and Secretary Yellen indicated that it was unlikely that cash and extraordinary measures would be exhausted before early June. Private estimates put that date a month or so farther out, but there is some uncertainty when making this call as tax receipts, rising rates, suspension of student loan debt repayments, and a range of other factors all contribute.

So What’s at Stake?
No one wants the US to default on its debt – and no one wants a government shutdown. Current polling indicates that 40% of voters would blame both parties for a default, and the narrow congressional majorities in both chambers combined with Biden’s low approval rating suggest that neither side has much to gain from a showdown. In this environment, we expect both sides to reach an agreement at the 11th hour that includes some spending cuts in exchange for lifting the debt ceiling.

But until that happens, we can expect both sides to make extreme requests in their opening salvos before they start walking those back to the middle. Republicans are looking for spending cuts, specifically:
  • A resolution that adopts a balanced budget within 10 years.
  • Reforming mandatory spending programs like Social Security and Medicare/Medicaid.
  • No debt limit increases without a budget agreement or commensurate fiscal reforms.
  • Fiscal year 2024 spending at FY 2022 levels – which requires some $130 billion in spending cuts.
Complicating the Matter…
Divided government adds complexity to the situation. Both the House and Senate are controlled by narrow majorities, making it crucial to keep everyone in line. There are also new rule changes in the House, making it easier for individual lawmakers to clog the process and shifting power away from leadership. As we have already seen, this can enable a small number of lawmakers to band together and muck up the legislative process.

Speaker McCarthy needs to keep the Freedom Caucus in check while also showing the party and his constituents that he can govern responsibly. One possible easy win? Cut the new IRS funding authorized in the Inflation Reduction Act. This would simply return IRS funding to previous levels with no real concessions given up by Biden – both sides could declare a win.

Regarding Those Extraordinary Measures…
As mentioned, the Treasury Department has taken extraordinary measures before, with relatively little fanfare. Some of the techniques:
  • Prioritize payments on Treasury securities to prevent a default – As existing securities mature, Treasury can issue new debt of the same principal amount, thereby keeping the stock of outstanding debt constant. To do this, Treasury would need to delay payment for obligations such as Social Security and Medicare and other government contractors until it had sufficient cash on hand to make the payments.
  • Suspend investment in the G Fund and reinvestment in the Exchange Stabilization Fund (ESF) – The G Fund is basically a money market fund that is part of the Thrift Savings Plan, which is the military and government’s retirement plan. The ESF is money set aside for foreign currency intervention and, more recently, was used to guarantee deposits in money market funds in response to the Covid-19 pandemic. Both of these facilities are notionally invested in overnight nonmarketable Treasury securities and are “invested in” for accounting purposes, but do not count against the current debt limit. Suspending investment would free up additional proceeds to be used elsewhere.
  • Declare a “debt issuance suspension period” – This would entail redeeming or suspending new investments into the Civil Service Retirement and Disability Fund and Postal Service Retiree Health Benefits Fund.
What About the Federal Reserve?
The Fed could allow full allotment of renewable repos, where it effectively takes any and all Treasuries off Wall Street’s balance sheets. It could also invoke Section 13(3), which allows the Fed to provide liquidity against Treasuries for anyone who wants to lend them to the Fed. These measures would effectively transfer the default risk to the Fed, which can take losses but would be able to ride through the volatility until the issue is resolved. And finally, Treasury could tap into the $14 billion of debt ceiling headroom sitting on the Fed’s balance sheet that’s left over from the pandemic-era interventions by the Fed and Treasury.

Other Alternatives
There are other ideas that have been mentioned in lieu of a negotiated solution, but please note, we are not constitutional scholars – just reporting in:
  • The Trillion-Dollar Coin (for real) – The way this works is that Treasury can use its discretion to mint a platinum coin and denominate it as a trillion dollars. Treasury then deposits it, effectively raising cash to cover existing debt obligations. Sounds easy, right? But good luck defending the constitutionality and subsequent legal challenges of such a move. Republicans would likely argue that this violates congressional intent and could result in lawsuits related to separation of powers.
  • The Fourteenth Amendment – Amendment 14 states that “the validity of the public debt… shall not be questioned.” Proponents say that this statement gives the president the ability to simply ignore the debt limit. The original intent of the article (ratified in 1868 – three years after the end of the Civil War) was partially based on fears that a future Congress dominated by formerly Confederate states would repudiate federal debt or guarantee Confederate debt. Again, good luck defending the legality of this, as well as the usurpation of congressional authority (Congress controls the purse strings).
  • Using the Discharge Motion – Whereas normal House procedures require the approval of a committee chair as well as the Speaker to be introduced for a floor vote (thereby preventing any Republican members from “crossing the aisle”), a discharge petition allows for legislation to avoid those steps. Ultimately, this move allows for a petition raising the debt limit to move through Congress without the House Speaker’s and most of the Republican conference’s buy-in. Should all Democrats sign the petition, six Republicans would also be required – and pressure on these six would be intense to hold the line…
    • A petition to discharge is a very lengthy and time-consuming process. Any House bill would have to be accepted word for word by the Senate. Any changes made in the Senate would require another vote in the House.
    • A bill can be introduced and then must sit in committee for 30 legislative days. Once the 218 signatures are collected, there is a 7-day legislative waiting period. After this waiting period, the bill can be considered on the next second or fourth Monday of the month.
    • All told, and depending on the congressional calendar, 37 legislative days could take several months.
This ultimately leaves only two likely outcomes:
  1. Pass a law raising the debt ceiling or suspending the debt limit.
  2. Default.
This is why we expect a down-to-the-wire negotiation that results in a last-minute agreement.

Market Impacts
While we’re sure to see plenty of nasty headlines in the coming weeks and months, historically the stock market has ignored the issue until the default date is much closer. In 2011, stocks slid about a month before the deadline and accelerated as the deadline drew close. We’re still some five to six months out from this, so the market is likely to ignore the issue for now.

The bond market will likely see a kink develop in the curve, but the long end of the curve should benefit from a flight to safety. Treasury bills that mature in the mid-to-late summer should start to see a premium reflecting the potential for a missed payment. But historically, once the drama has come and gone, these premiums correct and rebound.

However, the current economic backdrop complicates the situation. It’s always difficult to isolate the impact of a specific event in history and its impact on financial assets. In this case, we are dealing with inflation and job market worries all feeding into uncertainty surrounding US interest rate policy. These economic factors will likely remain in the driver’s seat in the near term.

Coming Later This Year: Government Shutdown?
Congress will need to pass legislation to extend federal spending authority past the end of this fiscal year by September 30. Expect more fireworks for this one as well. In our view, a government shutdown because of a lack of an agreement on funding is highly likely.

Fortunately, shutdowns tend to have a fairly modest economic impact: Estimates place the number at 0.10% of GDP growth for every week of shutdown. The main impact is lost compensation for federal employees who are considered non-essential (roughly 38% of the 2.1 million non-postal federal employees during the most recent episodes). Most of the lost activity can be made up in the following quarters; however, spending on services cannot be inventoried and can result in permanent loss. Keep in mind that the government is funded through the current fiscal year, which ends on 9/30/23.

Bottom Line
This too shall pass, but the ride will be bumpy given the highly toxic political environment in Washington, DC. Negotiations will come right down to the 11th hour. This is not an issue over willingness to pay, nor about ability. This is about the willingness to extract an ounce of flesh before enacting the willingness and ability to pay.

It will get done. The US won’t default. We’ll all move past this.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Natixis Investment Managers, or any of its affiliates. The views and opinions expressed are as of January 2023 and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted, and actual results may vary.

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