U.S. debt-ceiling talks skidded to a halt late Tuesday, with negotiators who met at the White House failing to make any significant progress on lifting the $31.4 trillion cap ahead of the June 1 default warning from Treasury Secretary Janet Yellen.
However, while global stocks are in retreat — equity investors are paring risk in light of the bitterly partisan talks — bond investors have shown little concern over the so-called catastrophic risk the economy faces should the U.S. run out of cash and default on its debts in coming weeks.
The latter description, of course, represents the way debt ceiling talks, and their potential consequences, have been characterized by both side of the negotiations as well as the non-financial media.
“It’s Congress’s job to [raise the debt ceiling],” Yellen said last month. “If they fail to do it, we will have an economic and financial catastrophe that will be of our own making.”
A truer reflection of the risks, however, can be found in both a sharper dissection of both the nature of the impasse and the bond market’s — at least to this point — muted reaction.
“No one in the market really believes some lasting catastrophe will come from the debt ceiling because it won’t,” said David Bahnsen, chief investment officer at Bahnsen Group, the Newport Beach, Calif., wealth management firm.
“It is pure political theater along the way, and in a sense, the market can become a prop for one or both sides of the political aisle to use to help negotiate,” he added.
Currency Sovereignty Negates the Risk of Default
Firstly, it’s worth noting that the U.S will not run out of money on June 1. The U.S. controls its own currency, in terms of minting its creation, determining its value and establishing the interest rate around which it is priced in international markets.
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Known as “currency sovereignty,” this ability effectively ensures that the U.S. can’t truly default on its debts in any meaningful way, since it only has to print new money (or issue new debt) in order to pay its bills.
That means what’s at stake on June 1 is an administrative and political hurdle, not an existential crisis.
The Treasury won’t be able to authorize any further payments without the approval of Congress, which has constitutional control over the nation’s purse strings, now that the $31.4 trillion ceiling — last increased in December 2021 — is about to be reached.
Nearly all the world’s advanced economies have abandoned, or declined to introduce in the first place, the idea of a fixed borrowing cap, preferring instead to benchmark borrowing as percentage of GDP.
This gives governments the flexibility to add more debt when the economy is weakening (in order to spark growth) while trimming it when the economy is in good health.
Capping overall debt at $31.4 trillion — or any amount for that matter — eliminates that flexibility. It also creates a strange fiscal paradox in which lawmakers can approve new spending (or tax cuts) in one session, only to then refuse to increase the debt needed to pay for them in another.
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As absurd as that seems, however, it doesn’t create the kind of end-of-the-world risk that the political players enmeshed in the debate describe.
“It is important to note that even if the (June 1) X-date is reached without new debt ceiling legislation, the risk of a technical default by the government on its debt remains low,” said Jason Pride and Michael Reynolds of Glenmede’s Investment Strategy.
“If the X-date is hit before a debt-ceiling raise, the government can prioritize interest payments on its outstanding debt. This avoids default while providing additional time for congressional leaders to hash out a deal.”
And that’s been evident in the market’s reaction to the long-simmering crisis.
Foreign Buyers Chase 2-Year Auction as a Safe Haven
Benchmark 2-year Treasury note yields, which move in the opposite direction of prices, have fallen from around 4.4% at the start of the year, when debt-ceiling risks first began to materialize, to around 4.285% today.
Now, while it’s true that bond yields are higher now than they were in early May, the movements haven’t reflected any true concern for near-term default.
In fact, the U.S. Treasury sold $42 billion in new 2-year notes yesterday, securing a yield of 4.3%. The Treasury saw foreign investors take down 68.2% of the entire auction, the highest level since 2009 and the second-highest on record.
Thus not only are foreign investors unconcerned with default risk, they’re willing to bid competitively against one another in order to find both a safe-haven store of value while simultaneously helping fund American spending.
JPMorgan analysts also noted that last week that “if perceived progress toward a deal slows in coming days, this would be
incrementally bullish” for Treasury bond prices. It would pull yields lower in a flight-to-safety trade that would, counterintuitively, lower the government’s borrowing costs.
Bank of America’s closely tracked Fund Managers Survey, published last week, noted that a full 71% of respondents expected a debt ceiling resolution before the June 1 “X date” and were far more worried about recession, rate hikes and commercial real estate risks than they were about a U.S. default.
Markets have, however, demanded a premium to lend the government money on a shorter-term basis, with the yield on 1-month Treasury bills rising to a record 5.892% in overnight dealing, to compensate for the added risk of the U.S. being unable to meet the full payment responsibility in early June.
But the higher yields aren’t only a reflection of risk, as bets on another Fed rate increase are speeding up following solid April retail sales data, a robust job market and improving conditions in the banking sector.
CME Group’s FedWatch, in fact, suggests a 49.1% chance of a July rate increase, up from just 19.8% a month ago.
“A debt ceiling deal is a certainty and every market actor knows it,” said Bahnsen. “The only issue along the way is short-term traders playing the ebbs and flows of the process … and we call that noise.”
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