Schwab Market Perspective: Debt Ceiling Standoff

The meeting was the first face-to-face discussion between President Joe Biden and House Speaker Kevin McCarthy (R-Calif.) since February. Both reiterated their incompatible positions. The president and congressional Democrats continue to stand by their long-held position that Congress should pass a clean debt ceiling increase with no strings attached, while Republicans say they will only consider lifting the debt ceiling if it is paired with spending cuts and other policy priorities.

The need for a resolution is becoming urgent. Treasury Secretary Janet Yellen told Congress in a May 1^st letter that the U.S. could default as soon as June 1^st, though her letter indicated that the imprecision of predicting Treasury revenues and outlays could push the default date later into the summer. That uncertainty has made it difficult for Congress to set a real deadline for negotiations.

The Republican majority in the House narrowly passed a bill on April 27^th that would raise the debt ceiling by $1.5 trillion or until March 31, 2024, whichever comes first. The bill also outlined nearly $5 trillion in spending cuts over the next 10 years, though it did not include any specific cuts. The legislation also would repeal about $72 billion in funding for the IRS and repeal several green-energy provisions that were approved last year as part of the Inflation Reduction Act; streamline the permitting process for energy projects; increase work requirements for recipients of food stamps and Medicaid; and claw back unspent funds that were allocated to fight the COVID-19 pandemic. McCarthy has repeatedly said that the House bill should be the starting point for negotiations. But that bill is a nonstarter in the Democrat-controlled Senate.

Next steps are uncertain, though participants in the May 9^th White House meeting agreed to a follow-up meeting during the week of May 15^th. With the clock continuing to tick toward an unprecedented default, the pathway to a resolution remains as murky as ever.

The standoff also has heightened the uncertainty about the economy. A default would risk sending short-term yields higher, while riskier assets and the dollar would likely fall. This is the scenario that played out in the 2011 debt ceiling fight, which resulted in the U.S. federal government credit rating being downgraded by several rating agencies, including Standard & Poor's, to below AAA for the first time ever.

If no deal is reached, the Treasury has a couple of options:

1. Technical default. A technical default is defined as an extended period of time of non-payment of interest and principal on the debt. It happens from time to time in emerging-market countries, but not in major developed countries with the ability to pay. An actual default is more likely when a government does not have the ability to pay, which often results in a restructuring of the debt. In the U.S., the issue is an unwillingness to pay and assuming an agreement were eventually reached, investors would receive their interest and principal payments—likely with extra accrued interest.

The market reaction would likely be quite severe, however—potentially a spike in short-term interest rates, a drop in the value of the U.S. dollar, and a downgrade by major rating agencies. Banks and financial institutions that use short-term U.S. Treasuries for financing would likely bid up the price to secure liquidity. It could mean a long-term rise in the cost of borrowing for the U.S. government.

On the economic front, the spike in interest rates would likely cause a recession, sending the unemployment rate higher.

2. Creative possibilities: Premium bonds/minting a platinum coin/invoking 14th Amendment. Among the more creative suggestions that commentators have made is that the Treasury could issue premium bonds—bonds with higher coupons—that would generate a price that is above par, giving the Treasury more cash. It's not clear how this would work in practical terms. And the Treasury secretary has dismissed the idea.

There also has been a suggestion that the Treasury could mint a trillion-dollar platinum coin, place the money at the Fed and use the proceeds to pay the country's bills. This seems pretty far-fetched and potentially illegal.

Finally, there is talk that Treasury could invoke Section 4 of the 14th Amendment—which states that "the validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellions, shall not be questioned"—and just keep paying the bills. However, Yellen has downplayed that idea as well, calling it a "constitutional crisis" during a television interview on May 7^th.

Clearly there are no good choices for the Treasury. Even if feasible, these creative suggestions may not pass muster in court if challenged.

The debt ceiling debate, coming on top of banking sector turmoil, makes any more Fed rate hikes unlikely. The markets are already volatile enough from the impact of rate hikes. The longer the debt ceiling debate lingers, the more damaging it could be for the economy.

One of the brightest spots of the April jobs report was prime-age labor force participation, which rose to its highest level since March 2008. That underscores continued success in getting workers back into the workforce, which is exactly what the Fed has been looking for. It hasn't yet led to easing wage growth, however, as you can see in the chart below. As that takes longer to unfold, it will likely help keep pressure on the Fed to keep rates higher for longer.

The European Central Bank (ECB) has made it clear it was not finished with rate hikes after stepping down from a pace of 50-bp hikes to a 25-bp hike last week. ECB President Christine Lagarde stressed that there was more work to do in upcoming meetings—suggesting multiple rate hikes are likely in store—to manage the ongoing resilience of economic growth, strong wages and sticky core inflation.

Global technology stocks, in particular, may be at risk if the market prices in more rate hikes by year end than what is expected today. The chart below highlights the relationship between the tech sector and policy rates, using the market's outlook for the change in ECB rate by year-end as an example. Global tech stocks outperformed the market as the amount of expected rate hikes by year end faded, and underperformed as the market lifted its year-end rate expectations.