U.S Debt Ceiling... Too Close for Comfort?

The US debt ceiling is front and center across all financial new outlets and will likely be the driving factor behind macro market moves in the near future. Question is: does the market really understand what the debt ceiling really is? Or does the market assume it understands based on what is reported on CNBC? Here’s my shot at trying to clarify what the debt ceiling is, and how it might affect the macro picture over the next couple of months.

The US debt ceiling is tied to the US budget (which is set to officially expire on Sept 30, 2013 at midnight), and dictates how much the government can borrow to pay for public services. Back in 2011, the debt ceiling was set at $16.4 Trillion, which was technically reached on December 2012, but through some miraculous measures from the treasury department managed to continue operating. However, the U.S government has now reached a point where they no longer have the budget for non-essential activities (national parks, museums, etc.). Essential activities, air traffic control for example, would not be shut down.

At this point, the US government has two options:

1. Re-negotiate a budget and have all parties agree to it before the deadline (very unlikely at this point).
2. Agree to what is known as a “Continuing Resolution” (CR) which allows the government to continue to operate on last year’s budget. A CR that runs to December 31 is likely at the moment. Note that the political parties involved will drag out any sort of agreement to a CR until the last possible second like they always do, so an agreement is likely only by late Monday night.

Generally, a debt ceiling increase follows a CR or new budget agreement. Considering that the US’ economic growth is still fragile, running the economy at a deficit makes logical sense; as a result, the debt ceiling should be raised. Since sound, logical reasoning and political actions can deviate quite drastically at times, raising the debt ceiling could take some time. I wouldn’t be swayed by financial media outlets about the next few weeks; it is much easier to grab viewer attention by claiming the government is going to collapse rather than reporting that all will be well. Don’t take this as a statement that a government shutdown in the US won’t happen; I’m just saying it is unlikely to happen.

A US government shutdown is likely to lead to a widespread risk-off move in equities and a rally in bonds (which was counter intuitive considering the situation) if the market reacts the same way it did in 2011.

Final thought: Keep an eye on market movement leading into the Monday deadline as well. If the market is pricing in a more bearish scenario than is necessary, you may have a trade on your hands. 

p.s. I think it is interesting to note that in 2007, Senator Obama voted not to increase the debt ceiling for President Bush’s administration. He also fought to de-fund the Iraq war. Funny how the tables have turned: the Obama administration’s debt ceiling increase is being voted against and US politicians are trying to de-fund Obamacare (doubt that will work).

Until next time,

P.B

Toronto GISA-Blog Contributing Author