U.S. Debt Ceiling: We’ve Kicked the Can Down the Road to December —-

It has long been and remains my view that the US Treasury will not default upon its debt obligations- not even for a very brief period of time. Yet markets have been on edge for the past month as the date (October 18) by which the Treasury would have exhausted all extraordinary measures approached. Senate Majority Leader Chuck Schumer just announced a temporary agreement reached on increasing the debt ceiling through December. This is good for unless a political compromise was reached, the US Treasury would have been forced to switch to cash-only management in order to continue operations i.e. after October 18 the Treasury would have to operate on a cash-only basis.

The market implications from a technical Treasury default – a default in which bondholders would be paid in full but with some type of delay – are both wide-ranging and hard to anticipate. There are, however, two potential developments that would most seriously threaten the stability of financial markets: (i) a credit freeze in the short-term repurchase agreement (repos) market where Treasuries are used as collateral to secure short-term borrowing; and (ii) severe disruptions to the money markets since most money market funds (MMFs) invest heavily in US Treasury securities. The credit markets would freeze, if a handful of MMFs were to “break the buck” (where the net asset value (NAV) per share falls below USD 1. Even if the immediate impact was not dramatic, if a short-term default led investors to question the willingness of the US government to honor its obligations in a timely manner, then the impact could be both more far reaching and long lasting.

When the $480 billion debt hike is exhausted, the political gamesmanship from both parties will renew. Negotiations in Congress will likely heat up again towards the end of the year, as they renew attempts to forge a long-term deal. I think that the negotiations will continue and bleed into 2022 with rigidity on both sides to prove to their respective constituents that they stood their ground and boost their reelections chances at the next primaries. Congressional representatives have a strong incentive to fight until the last minute. Therefore, I again expect a last-minute deal to emerge, possibly as late as in late February or early March, when the Treasury will once again cease to be able to use book-keeping measures to operate under the ceiling. However, I don’t expect a drastic government shutdown.

Global Shutdown With US Economy Slipping into Recession

We modeled over twenty economic variables and all combinations point to probability of a severe recession. We hope our model is wrong. Despite unprecedented CARES life support stimulus, policy efforts, the combination of real economy shutdown and rapidly declining wealth has evoked sharply lower confidence. Total uncertainty about coronacrisis resolution, has prompted an abrupt retrenchment in consumers, corporate sectors, taxes and government finances. This threatens wide spill-over effects over the next few quarters.