Researchers Quantify Market Risks As Debt Limit Deadline Nears

Researchers at the Kansas City Fed have sized the market impact from last minute debt ceiling deals in a recent analysis. This occurs in cases where negotiations are close to the s0-called x-date, the time when the U.S. government is estimated to default.

They examine episodes in 2011, 2013 and 2021 finding that in these three cases short-term Treasury yields can spike by around 0.15 to 0.3 percentage points with impacts to other parts of financial markets too. This elevated volatility typically begins around 15 to 30 days before the x-date based on these historic episodes.

Summer Deadline

Congressional Budget Office estimates recently put the x-date between July and September 2023. Extraordinary measures have been in place since January, and the Treasury has estimated that funds will be exhausted at some point after June. That suggests that politicians still have some time before debt limit issues will impact markets. However, U.S. government debt credit default swaps have been rising over recent months, that may suggest fixed income markets are pricing in some risk already.

Restrictive Policy

The research also notes that monetary policy is currently restrictive with the Fed expected to continue raising rates and shrinking its balance sheet, whereas monetary policy has generally been looser during recent debt ceiling episodes. That may mean the market impact from debt ceiling negotiations are felt more strongly this time, should a resolution come close to the deadline. They argue that, “liquidity swings could be larger and more destabilizing today.”

On top of that, recession risk in the U.S. is potentially elevated on assessments such as the yield curve, that’s in part because the Fed is raising rates aggressively. If the markets are dealing with debt ceiling issues and slowing growth in combination then the debt ceiling issues could have greater impact.

Still Time

There is still time for the debt ceiling issue to be resolved and politicians are discussing solutions. Nonetheless, the clock is ticking even if several months remain. Extraordinary measures began on January 19. Now, based on this analysis, there is still some time, but without resolution in the next three months, then the x-date could then be a month away if, it were to fall at the early end of the estimated range. As the researchers estimate, there’s a risk markets then focus on the debt ceiling issue and volatility spikes. Of course, there’s also the slight risk that no resolution is found before the x-date. That’s not anticipated, but since we have no precedent for that, the market impact is unknown.