Weekly Update - Talks over US debt ceiling could trigger market turbulence

The US debt ceiling. The United States Federal government is butting up against a legal limit - the debt ceiling - set by Congress, which caps how much the Treasury can borrow. The ceiling, introduced in 1917 to allow exceptional public spending on the first world war, is a peculiarity of the United States system. In the past, the ceiling has been increased many times with no problems, 78 times since 1960. But, since the turn of the century, as public sector debt ballooned, the process has become a political hot potato, particularly when the sitting president lacks a comfortable majority in Congress. If they fail to lift the ceiling, the government will no longer be able to pay its bills, including redeeming bonds coming due. This would mean the US government defaulting on its debt.

A feeling of déjà-vu. On 2 August 2011, the debt ceiling was only raised at the very last minute before the country went into default, following a stand-off between the Obama administration and Republican lawmakers. The confrontation led S&P to downgrade its rating of United States public debt from AAA to AA+ on 5 August. As the political tensions were playing out, between July and mid-August, the S&P500 index plunged by nearly 17%. True, the fall can be partly attributed to banking troubles in the Euro area that summer, but it nonetheless illustrates the severe turbulence that a fight over the debt ceiling can provoke.

United States public sector debt has nearly doubled since 2021. The last time the ceiling was lifted was in December 2021 and the new ceiling was hit on 19 January. The government should be able to keep paying its bills until some time estimated between 1 June and 1 August, which means time is running out to strike a deal to lift the ceiling. Republicans have a slim majority in the Chamber and have tied any agreement to cuts in public spending, something the Democrats have so far refused to concede. The complex political wrangling is starting to feed through to markets. 1-year CDSs, the cost of buying protection against a possible default, have hit an all-time high and the rate of claims maturing after 1st June is rising.

Risks in the very short and medium terms. If the United States were to default on its bonds, which many market players use as a benchmark risk-free asset, it could plunge financial markets into instability. But while we cannot rule out such a scenario, we consider it unlikely. A likelier outcome in our view is that a last-minute deal is found that allows the ceiling to be lifted. But until such a deal is announced, the tensions already breaking out on the markets could get worse. Looking beyond the need to redeem short-term maturities, ongoing political talks suggest an agreement could include significant cuts to public spending in the future, which could mean a sharper slowdown in the US economy as from 2024.

Finally, in the main events of the week, we have chosen to talk about economic activity in China and to focus on the trade surplus in the Euro area.

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