What to watch in 2023: The next US debt fracas

A raising of the US debt ceiling must be negotiated anew almost every year. The debt ceiling usually gets raised without any major friction, but not without detours and often at the last minute. This year, however, the potential risks and side effects of the debt debate are graver than they’ve been in a long time. A tougher confrontational attitude in Congress indicates that a full-blown debt fracas in the Capitol looms, and it is unlikely to leave the financial markets indifferent.

Countdown to the showdown

The federal debt ceiling in the United States, which regularly has to be renegotiated and raised by Congress, will be reached in the days ahead. Using financial sleights of hand (“extraordinary measures”) that have become routine by now, the US Treasury can continue to meet its payment obligations for some time yet. Come summer, however, or perhaps not until October, all of the hacks and tricks will likely have been used up and federal coffers will be empty, and then a default looms. The protagonists in Washington, D.C., are well aware of this risk. The right wing of the Republican Party, which already revealed its destructive intentions in the disastrous soap opera surrounding the election of Kevin McCarthy to the Speakership of the US House of Representatives in early January, is actually bent on wreaking havoc and instrumentalizing the debt-ceiling-raising procedure to wring substantial budget-cut concessions from the Democrats, particularly in the area of social welfare spending. During the last three episodes of the debt debate in 2013, 2015 and 2021, the wrangling ultimately came to a conciliatory ending usually at “five minutes to midnight,” but this time dislocations as bad as or even worse than the ones caused by the debt-ceiling showdown of 2011 loom. Back then, it took a sovereign credit rating downgrade by Standard & Poor’s (from AAA to AA) and a more than 10% drop in the stock market to bring politicians and policymakers to their senses. A similarly dire scenario for 2023 cannot be ruled out. This year, it seems entirely possible that a last-minute deal won’t be reached and that the US Treasury will be hamstrung in its ability to act and make payments for days or even weeks, with attendant risks and side effects.

Maxed out again | The US Treasury will soon be out of cash

US federal debt load and debt ceiling (in trillions of US dollars)

Sources: Bloomberg, Kaiser Partner Privatbank

No default, but risks nonetheless

If the US Treasury runs out of money by autumn if not earlier, a worst-case meltdown in the form of a default on US Treasury bonds would not immediately loom. In 2011 and 2013, the Treasury Department and the US Federal Reserve crafted emergency plans to ensure the punctual servicing of federal debt while deferring other payments. A similar prioritization plan is in place for the potential funding shortage on the horizon today. As soon as the hole in federal coffers gets dangerously close, federal spending is likely to be reduced temporarily by 30% to 40%, but interest payments will be safeguarded. Even though the USA thus doesn’t face insolvency in all probability, the debt ceiling presents a risk that can’t be ignored because prices for US credit default swaps (CDSs) regularly have risen significantly even during the less contentious debt-ceiling debates in recent years. That could happen again in 2023. And there might also be dislocations on the US Treasury bond market, which has already been plagued by low liquidity lately in any case. The equity market is also unlikely to come away completely unscathed. Shares of companies (such as defense contractors) that would be affected by temporary spending halts or by permanent federal budget cuts potentially needed to end the debt fracas could particularly come under pressure. Protracted payment jams ultimately could also hurt consumer confidence. In 2011, uncertainty regarding the debt ceiling triggered the deepest plunge in consumer sentiment besides the one caused by the Great Financial Crisis. So, alongside volatile financial markets, economic growth also faces a potential setback. Altogether, the foreseeable debt-ceiling standoff arguably poses the biggest US domestic policy risk in 2023. European markets probably won’t be entirely spared from the potential chaos.

Conclusion: The last-minute “rescue” is a movie script that politicians in Washington, D.C., are all too familiar with. Precisely for this reason and due to the confrontation course that a few Republicans are dead set on, this year’s episode might not follow the classic screenplay for once. In the risk scenario, major dislocations on the financial markets and a small shock to economic growth loom. But even this year’s debt fracas likely will ultimately come to an end, and any asset-price dips will likely prove temporary.