US Debt Ceiling Crisis: Markets Hold Their Breath

Khan Capital | May 2023

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Key Takeaways

• The US faces its most contentious debt ceiling standoff since 2011, with one-month T-bill yields spiking above 5.5% and US sovereign CDS spreads at their highest in over a decade as the X-date approaches.
• The debt ceiling has been raised 78 times since 1960, establishing a pattern of political brinkmanship followed by last-minute resolution that conditions markets to treat the risk as theatre, creating complacency that would amplify the shock of an actual failure to reach agreement.
• The underlying fiscal trajectory, with structural deficits at 6% of GDP, debt-to-GDP exceeding 120%, and net interest payments approaching $700 billion, is the real risk that the debt ceiling debate highlights but does not resolve.
• A post-deal surge in Treasury issuance to rebuild the Treasury General Account will drain liquidity from the financial system and put upward pressure on short-term rates, a second-order effect that markets often overlook.
• The paradox of the Treasury market, in which US default risk drives demand for US government bonds because there is no alternative asset class with comparable depth and institutional embedding, illustrates both the privilege and the vulnerability of reserve currency status.

Part of: Rates, Bonds & the Macro Picture – Khan Capital’s hub on rates, bonds and the macro picture.

The United States government is days away from running out of money. Treasury Secretary Janet Yellen has warned that the “X-date,” the point at which the government can no longer meet all its obligations, could arrive as early as 1 June 2023. The House of Representatives, controlled by Republicans, has passed a bill that would raise the debt ceiling in exchange for spending cuts. The Senate, controlled by Democrats, and the White House have insisted on a “clean” increase without conditions. Negotiations between President Biden and Speaker McCarthy are ongoing but have not yet produced an agreement. The markets are watching, and while the consensus expectation is that a deal will be reached before the deadline (as it always has been), the financial system is pricing the possibility, however remote, that the United States of America might default on its debt.

The Market Impact: Pricing the Unthinkable

The financial market stress from the debt ceiling standoff is visible in several indicators. One-month Treasury bill yields have spiked above 5.5%, as investors demand a premium for holding instruments that mature around the X-date. Credit default swap spreads on US sovereign debt have widened to their highest levels in over a decade, briefly exceeding those of some emerging market sovereigns. Short-term money market dislocations have emerged as institutional investors avoid Treasury bills with maturities near the deadline. The VIX has edged higher, though it remains well below crisis levels.

Paradoxically, longer-dated Treasuries have rallied (yields falling) as investors anticipate that a potential default, or even a technical default involving delayed payment, would trigger a flight to safety that benefits the very same US government bonds whose creditworthiness is in question. This is the unique position of the US Treasury market: even in a scenario where the US government technically defaults, there is no alternative asset class that offers the same combination of depth, liquidity, and institutional embedding. The dollar’s reserve currency status and the Treasury market’s role as the foundation of the global financial system create a paradox in which US default risk drives demand for US government bonds.

The Pattern: Political Brinkmanship as Market Event

The debt ceiling has been raised or suspended 78 times since 1960. It has never not been raised. The pattern is well-established: both parties use the debt ceiling as leverage to extract policy concessions, take the negotiations to the brink, generate maximum political drama, and then reach an agreement in the final hours before the X-date. The 2011 episode, in which S&P downgraded the US credit rating from AAA to AA+ despite the eventual deal, is the closest the country has come to a genuine default. Even then, the government made all its payments on time.

The market has been conditioned by this pattern to treat debt ceiling crises as political theatre rather than genuine default risk. This conditioning is probably correct, but it creates a complacency risk: the more investors are convinced that a deal will always be reached, the more severe the market dislocation would be if, for whatever reason (political miscalculation, a procedural failure, an unexpected event that disrupts the negotiation timeline), one is not reached in time.

What the Market Is Misunderstanding

Even a deal does not resolve the underlying fiscal trajectory. The debt ceiling debate focuses attention on the symptom (the statutory limit on borrowing) rather than the disease (the growing structural deficit). The US fiscal deficit is running at approximately 6% of GDP outside of a recession, a level that is historically unprecedented in peacetime. Federal debt-to-GDP has exceeded 120%. Net interest payments on the debt are approaching $700 billion annually and rising rapidly as low-coupon bonds mature and are refinanced at current yields. The debt ceiling will be raised (it always is), but the fiscal trajectory that makes each ceiling increase necessary will not change as a result of the deal.

The 2011 downgrade precedent is underappreciated. When S&P downgraded the US in 2011, Treasuries paradoxically rallied (yields fell) as investors fled to safety. But the long-term consequence was a persistent increase in the premium the market demands for holding US government debt. The term premium, which had been declining for years, began to stabilise. A repeat downgrade from Moody’s (the last major agency to maintain a AAA rating for the US) would be symbolically significant even if the immediate market impact was, as in 2011, a paradoxical rally in the very asset whose credit quality was being questioned.

The technical mechanics of default are more complex than a simple “missed payment.” If the X-date arrives without a deal, the Treasury would likely prioritise debt service payments (bond interest and principal) over other government obligations (Social Security payments, federal employee salaries, contractor payments). This “prioritisation” approach would avoid a technical default on Treasury securities but would represent an extraordinary disruption to government operations and a de facto austerity shock that would weigh on economic growth and consumer confidence.

Implications for Investors

Avoid Treasury bills maturing near the X-date. The risk premium on bills maturing in early June is elevated and reflects genuine uncertainty about timely payment. Money market funds and cash management strategies should be positioned to avoid concentration in the at-risk maturity window.

A deal will likely be followed by a burst of Treasury issuance. Once the debt ceiling is raised, the Treasury will need to rebuild its cash balance (the Treasury General Account at the Fed), which has been drawn down to fund operations during the ceiling constraint. This will require significant new bill and bond issuance, which will drain liquidity from the financial system and put upward pressure on short-term rates. The post-deal issuance wave is a second-order effect that is often overlooked.

The long-term fiscal picture is the real risk. The debt ceiling drama will pass. The underlying fiscal trajectory, structural deficits exceeding $1.5 trillion annually, rising interest costs, and the absence of political will to address either spending or revenue, will not. Investors with long time horizons should consider the fiscal trajectory as a source of persistent upward pressure on long-term interest rates and a tailwind for gold, TIPS, and real assets that benefit from government profligacy and currency debasement concerns.

Equity markets will likely rally on a deal. The resolution of the debt ceiling uncertainty removes a headwind that has weighed on sentiment. Historical precedent (2011, 2013) suggests a modest equity rally following a deal, as the market’s attention shifts back to fundamentals (earnings, monetary policy, economic data) that have been temporarily overshadowed by the political drama.

Conclusion

The debt ceiling crisis is a self-inflicted wound that the US political system inflicts on its financial markets with dispiriting regularity. A deal will almost certainly be reached, as it always has been. The government will not default, as it never has. But the episode serves as a reminder that the world’s reserve currency and the global financial system’s foundational asset, the US Treasury bond, rests on a political foundation that periodically shakes. The real risk is not the debt ceiling itself but the fiscal trajectory that makes each ceiling increase larger, each negotiation more contentious, and each brush with default a little closer to the edge.

Related Reading

The debt ceiling standoff came amid broader fiscal concerns. For the bond market backdrop, see 10-Year Treasury Hits 5%: Bond Vigilantes Return.

For the fundamentals behind this story, start with the dollar’s reserve role and how CDS price default risk.