Navigating The Debt Ceiling Crisis
Global monetary policy hinges on the value of a risk-free asset plus a premium, and for years, US Treasuries have played this role effectively. Treasured for their liquidity and safety, they have served as collateral in countless global trade transactions. The US government issues these Treasuries to fund its operations, relying on revenue, primarily from taxes, to service the debt. While the probability of a US Treasury default remains minuscule, the recurring eleventh-hour debt ceiling raises have sparked doubts among nations about conducting global business in the US currency.
Understanding the Debt Ceiling Dilemma
The underlying issue boils down to the US government consistently spending more money than it accumulates over several years. This practice pushed the government to hit the debt ceiling of $31.4 trillion in mid-January. To keep the financial wheels turning, the Treasury Department tapped into its "checking account," the Treasury General Account (TGA), along with an emergency fund. Initially projected to suffice until the end of August, these funds, combined with tax revenues, might run dry as early as June 1st, courtesy of lighter-than-expected tax collections and special circumstances, like disaster relief.
Assessing Risks
Comparing the current situation to the 2011 debt ceiling showdown, the S&P 500 lost nearly 20% in a four-month window, with a significant portion of the drop occurring shortly before the potential default. Presently, the risk is apparent as reflected by the CDS index at 70.8 BPS and a positive S&P 500, indicating high risk.
Another concern is a mismatch between the Treasury's debt and income requirements. Similar to regional banks, the Fed has considerable short-term debt maturing but requires immediate funds. Refinancing this debt today involves significantly higher interest rates compared to several years ago. This added interest or deferred balance must be covered before releasing the funds to the Treasury. What once funded the Treasury with $90 billion per year from interest payments has flipped in the past six months, creating a $42 billion liability to be settled down the road. This tightens the time frame for Congressional action, with each passing month increasing the deferred amount by $7-8 billion in debt.
The Road Ahead
The timeline ahead is demanding:
On May 9th, the 'Big 4' members of Congress will meet with the President to negotiate a deal.
On May 19th, the President embarks on a trip to Japan and Australia.
On May 26th, Congress is on recess for Memorial Day.
Should no resolution be reached, the Treasury would rely on tax revenue and maturing bonds while issuing new bonds to replace maturing debt. In 2011, the Treasury indicated it would prioritize interest payments and Medicare, followed by equal payments to other obligations. Not receiving the full amount owed on a debt obligation constitutes a technical default, causing challenges and potential lawsuits if the debt ceiling isn't raised. To learn more about our tailored investment strategies.
Potential Short-Term Solutions
Two main solutions have been proposed to mitigate market turmoil when the debt ceiling isn't raised:
Premium Bonds: These two-year bonds could be issued at a 5% premium above current rates, generating substantial upfront liquidity but also adding uncertainty and volatility to a traditionally stable market.
$1 Trillion Coin: The Treasury could mint a $1 trillion coin and deposit it with the Fed to create immediate liquidity. While offering a temporary solution, it introduces uncertainty and potential market volatility. Check out more on the history of the trillion dollar coin.
Investments Going Forward
We are monitoring two primary risks: a significant breakdown in equity and bond markets and the potential for money market funds to break Net Asset Value (“NAV”). Our investments remain conservative, prioritizing stability, security, and safety for clients' cash investments, especially in money market funds. Discussions with our custodian partners, Fidelity and Schwab, are ongoing regarding money market funds in light of the debt ceiling risk.
While we don't foresee a liquidity crisis due to market conditions, a failure to increase the debt ceiling could impact short-term funds associated with treasuries. We will continue to monitor the situation closely and proactively follow our integrated approach to wealth management. To learn more about our integrated approach to investing, see Financial Planning Approach - Client First Capital.
