What’s Next For Markets As The U.S. Reaches It Debt Limit?

The clock is ticking on the U.S. debt limit, which was already technically reached on 19 January 2023. The U.S. Treasury currently estimates that emergency measures which are expected to extend the most severe impacts of the debt limit by several months, will be exhausted in June 2023. The economic risks are potentially high.

Of course, many expect politicians to reach an agreement to raise the debt limit prior to June, but what if they don’t? Financial markets are showing some concern, credit default swaps on U.S. government debt, have reached multi-year highs, though haven’t yet approached the levels we saw in 2011, when the U.S. potentially came within a few days of default and S&P downgraded the U.S. government’s credit rating.

Further Emergency Measures?

If political negotiations do stall, then it’s possible the Treasury is able to do more to push out the deadline using even more extreme emergency measures, or using speculative tactics such as minting very high value coins. Under emergency measures currently in force since mid January 2023, the Treasury is temporarily borrowing from government pension and benefit plans to provide liquidity to run the government. Though not ideal, that’s permitted by law and it’s been done before. These borrowings will be repaid in full once the debt limit is increased.

Still, it’s important to note that the U.S. debt limit has already been reached, meaning we are already on borrowed time. On current estimates by June, the Treasury would be forced to make increasingly difficult and ultimately unsustainable trade-offs. At a certain point, measures to avoid a debt default might push the U.S. into recession, if for example, social security payments or paychecks to government employees were delayed. So it’s unclear how far the Treasury could push a technical default beyond June, and how damaging the economic impact would be from juggling the accounts. The U.S. yield curve is currently deeply inverted, a common recession signal, so further issues with the debt limit may disrupt the U.S. economy at a precarious time.

U.S. Credibility In Financial Markets

The credibility of U.S. government debt would also be impacted. Currently, the U.S. government enjoys relatively low borrowing costs compared to other government borrowers. If the forecasted June limit is reached, then similar to 2011 when U.S. debt was downgraded, the current faith in U.S. government debt in financial markets, may be questioned. Elevated credit default swaps already point to some concern in markets.

Academics have estimated that U.S. borrowing costs may be lower than otherwise, because of the strong position of the U.S. in government debt markets. That benefit is potentially tens of billions of dollars annually in lower interest payments for the U.S. government, when compared to other countries. If the debt ceiling delay causes the U.S. to default on interest payments, or come very close to it, then borrowing costs for future years may increase. Of course, high U.S. debt levels may already pose a risk for the U.S. economy, but the debt limit is about making good on past spending commitments, not setting future spending levels.

A Deal Before June?

The U.S. has historically reached agreements on raising the debt limit many times across multiple administrations, and it’s likely 2023 will be no different. However, as 2011 showed, if the government does delay raising the ceiling too long, then the economic impact on the U.S. could be severe, especially at a time when recession fears are high.

It’s worth noting though, that the political setup is perhaps a cause for concern. In 2011 raising the debt ceiling was a very close call. In 2011 we had a Democrat President after the Republicans retook the House in the midterm elections the year prior, a similar picture to 2023. It’s likely the debt limit is raised without incident, but, if not, the economic impact could prove extreme.