Download The US Debt Ceiling: Age of reason*

The US Debt Ceiling: Age of reason*
Economic research note
22 October 2013
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The US Congress has agreed on a deal that ends the
government shutdown, funding spending to 15 January
2014 and suspends the debt ceiling until 7 February
2014.
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In addition, a Committee will be established to work on
a medium-term budget plan. This Committee is due to
report by 13 December 2013.

Financial markets have welcomed the deal, as it avoids
the worse-case scenario of a possible default on US
government debt and has seen the government reopen.

However, the short-term nature of the deal holds out the
risk of yet another round of acrimonious negotiations in
early 2014 and another opportunity for market
disappointment and volatility.

Given the nature of the debate over the past few weeks
and indeed as was the case in August 2011, it is hard to
imagine why the US political system will deliver a
smoother and more cooperative negotiation process
early in 2014.
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Indeed, given the short-term nature of the budget and
debt ceiling deals, we could see this argument resurface
at least two more times before the November 2014 MidTerm elections.
The economic uncertainty created by this debate over
the budget and the debt ceiling could be a factor that
sees the US Fed further delay its tapering of QE3 into Q1
2014.
The US Debt Ceiling: Age of reason
The US Congress (both the Democratic controlled Senate 8118 and the Republican controlled House of Representatives
285-144) has come to an agreement to end the government
shutdown (the government reopened last Thursday) and
suspend the debt ceiling.
The deal, which was passed just ahead of the 17 October
deadline, will fund the government at current levels until 15
January 2014 and suspend the debt ceiling until 7 February
2014. The Treasury will also continue to be able to use
‘extraordinary measures’ to fund the government, meaning
the debt limit will not need to be raised until well after the 7
February deadline, perhaps into March or even April.
The deal also establishes a Committee to work on details of a
medium-term budget plan and report back on options by 13
December 2013.
This compromise deal has been welcomed by financial
markets, as it avoids the worse-case scenario of a possible
default on US government debt and allows government
employees back to work, supporting the economy.
But, the deal is only very short-term in nature. It is hard to
imagine that come the New Year, the fight over the budget
and the debt ceiling won’t be equally as combative and
disruptive as the episode we have just lived through or, for
that matter, the debate in August 2011.
Indeed, given the nature of this debate and the subsequent
short-term deal that has been done, it is likely that we could
see a repeat of the recent unsettling market conditions at
least twice more before the November 2014 Mid-Term
elections.
This is likely to be a negative factor for the US economy over
the medium-term and could see the Federal Reserve delay its
planned tapering of QE3 (see below for further details).
We also note that with the government shutdown ended that
the September payrolls data will now be released on 22
October, the September CPI report on 30 October and the
October payrolls report on 8 November.
Ryan Felsman
Senior Analyst,
Economic and Market Research
Stephen Halmarick
Head of Economic and
Market Research
James White
Senior Analyst,
Economic and Market Research
US debt ceiling:
As shown in the following chart, the US debt ceiling has been
hit and raised on many occasions over the past 20 years or so.
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Sometimes this process is politically charged and leads to
significant volatility (as in 1995-96 under President Clinton and
in August 2011 and currently under President Obama), but
sometimes the increase is procedural and smooth.
The debt ceiling is a self-imposed limit on the total value of US
Federal government debt outstanding. It is not a ‘limit’ in the
sense that investors are unlikely to lend the US government
any more money beyond a certain amount (ie. cease buying
US Treasury bonds), but acts as a vehicle for a regular
discussion on how much debt the US government is accruing.
US debt ceiling and actual debt on issue
Having been so acrimonious this time around, it is hard to see
how or why any future budget/debt ceiling negotiations would
be any different.
Indeed, the risk is that as the November 2014 Mid-Term
Elections draw closer, that the political environment in
Washington will become more and more combative. For
example, the filing deadline for major political party
candidates in Illinois commences in December 2013, with the
State primary elections running all the way through to
November next year. This is likely to only cause more
uncertainty for the US economy and volatility in financial
markets.
Credit rating implications:
In August 2011 when the US was embroiled in a debate over
the debt ceiling, its credit rating was downgraded by Standard
& Poor’s (S&P) from AAA to AA+. At the time, and since then,
both the other major credit rating agencies, Moody’s and Fitch,
had maintained the credit rating at Aaa or AAA.
However, on 16 October 2013, the Fitch rating agency has
placed the US long-term foreign and local currency AAA credit
rating on ‘Rating Watch Negative’ (RWN).
Source: Bloomberg, data to 16 October 2013.
While this may in fact be a good thing, the problem is that the
US debt limit has clearly become a ‘bargaining chip’ for allsorts of desired policy outcomes, especially when the House of
Representatives and the Senate are ruled by opposing parties
– as is the case now.
The key issue for markets is that the US Treasury is not allowed
to issue debt above the limit. Of course, given that the US
government is currently running a Budget deficit of around
$US600bn-$US700bn per year, an inability to issue more debt
would see government payments cut right across the board including social security, government employee wages,
interest payments on outstanding debt and the repayment of
maturing debt.
The danger is, therefore, that an inability to issue more debt
could threaten the timely payment on interest (coupons) on
bonds outstanding and/or repayment of maturing bonds.
As has been well documented, a failure along these lines
would likely have significant negative implications for the US
government’s credit rating, interest rates across the yield
curve and the real economy.
Political implications:
Although it is a positive that the US has done a deal to lift the
debt ceiling and end the government shutdown, the negative
is that this deal is rather short-term.
The issue is, of course, that the same concerns around the
debt ceiling and the medium-term budget outlook are likely
to dominate any future discussions.
In announcing the move to RWN, Fitch stated that “although
Fitch continues to believe that the debt ceiling will be raised
soon (as it has), the political brinkmanship and reduced
financing flexibility could increase the risk of a US default.”
Fitch also stated that “the prolonged negotiations over raising
the debt ceiling risks undermining confidence in the role of
the US dollar as the preeminent global reserve currency.”
In addition Fitch noted that “the repeated brinkmanship over
raising the debt ceiling also dents confidence in the
effectiveness of the US government and political institutions,
and in the coherence and credibility of economic policy. It will
also have some detrimental effect on the US economy.”
Fitch has noted that they plan to resolve the RWN by the end
of Q1 2014 at the latest.
The key issue here is not whether the US government would
eventually raise the debt ceiling (as they have), but the
extreme brinkmanship, uncertainty and volatility that
surrounds the process. These factors strongly suggest that
Fitch is quickly losing patience and that a credit rating
downgrade could be expected.
While not commenting on the US’s credit rating specifically,
S&P have released a statement (16 October 2013) on the
economic impact of the shutdown, stating that “we believe
that to date, the shutdown has shaved at least 0.6% off the
annualised fourth-quarter 2013 GDP growth, or taken
$US24bn out of the economy.”
Perhaps more importantly, S&P also stated that “the short
turnaround for politicians to negotiate some sort of lasting
deal will likely weigh on consumer confidence, especially
among government workers that were furloughed. If people
are afraid that the government policy brinkmanship will
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resurface again, and with it the risk of another shutdown or
worse, they’ll remain afraid to open up their cheque books.”
Policy implications:
One of the key implications of the US government shutdown
and the uncertainty created by the debt ceiling debate is likely
to be a softer than otherwise economy, at least in Q4 13.
With some government workers stood down for a period, the
economy will be weaker than otherwise would have been the
case – although the government has promised to pay backpay now that the shutdown has ended.
Importantly, there was a lack of official economic data
released during the shutdown (especially the critical monthly
payrolls report) and this is likely to complicate the US Federal
Reserves (the Fed) desire to begin the process of tapering
their economic stimulus program (QE3). As noted above, key
economic data will now start flowing again.
Expectations are now building that the combined effect of the
shutdown and the uncertainty created by the debt ceiling
debate could delay any tapering of QE3 into Q1 2014, rather
than December 2013.
In this regard it has been interesting to note that even the
ultra-hawk on monetary policy, Dallas Fed President Richard
Fisher has stated that the uncertainty created by the
government shutdown and debt ceiling debate means that
now is not a good time for the Fed to be moderating the QE3
program. This is likely to be much more so the case for the
incoming Chair, Janet Yellen.
US Fed balance sheet and 10yr bond yields
Fed Balance Sheet $UStr
10 year Treasury Yield %
5.50
4.0
5.00
3.5
4.50
3.0
4.00
3.50
2.5
3.00
2.0
2.50
1.5
2.00
1.0
1.50
1.00
2003
0.5
2005
2007
10-year Treasury yield
2009
2011
2013
Fed balance sheet
Source: Bloomberg, data to 16 October 2013.
* Note:
“Age of reason” refers to the Black Sabbath song, not John
Farnham.
“Do you hear the thunder, raging in the sky?
Premonition of a shattered world that's gonna die.
In the age of reason, how do we survive?
The protocols of evil ravage through so many lives So many
lives.”
With the govern shutdown/debt ceiling deal now likely to
mean another round of acrimonious political debate early in
the new year, the risk is that the US Fed may find the 29-30
January meeting (the last with Bernanke as Chair) too early to
reduce QE3. This would then put the focus on the 19-20
March meeting, the first for Janet Yellen as Chair.
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