PIMCO: On-and-off-and-on-again progress toward a US debt ceiling agreement
It is our view – with high conviction – that the recent on-and-off-and-now-on-again negotiations will result in a debt ceiling deal ahead of the U.S. Treasury’s “X date” on June 1 (i.e., the estimated date when the federal government would no longer have enough funds to pay its bills) – although possibly not until the (literal) eleventh hour.
After all, while neither side seemingly has a political incentive to make concessions before they absolutely have to, neither side has any political incentive to default either. To use an apt, albeit graphic analogy: Passing the debt ceiling is like passing a kidney stone – we know it will pass, it is just a question of how painful it will be. We would assert we are in the painful period right now.
Indeed, while each side of the political aisle has been testing the contours of a possible debt ceiling deal with new asks (i.e., immigration reform for Republicans, tax increases for Democrats), the broad outline hasn’t changed much over the past few weeks: reclaiming unused COVID-19 money, caps on 'discretionary' spending (which represents roughly 25% of the U.S. government’s $6 trillion annual budget), work requirements for specific entitlements (which poll quite well but tend to be burdensome to administer, and therefore do little from a deficit perspective), and potentially some down payment on energy-permitting reform (both traditional and clean energy). We could also see tweaks to how Medicare reimburses providers for hospital treatments.
The real obstacles, however, seem to be in the specific spending details:
- Setting the so-called spending baseline for fiscal year 2024: If FY24 spending is reset to FY22 levels – the Republicans’ ask – it would likely drive short-term cuts in discretionary spending and produce longer-term deficit savings. If FY24 spending is set at FY23 spending levels – the Democrats’ preference – this would likely represent a freeze in discretionary spending (i.e., no cuts), but nevertheless represent longer-term deficit reduction over 10 years.
- The depth and composition of the spending caps: The questions amount to how much slower spending growth would be when compared with the Congressional Budget Office’s (CBO) projections (i.e., how much will growth be “capped”) and how those caps would be levied on non-defense discretionary spending (everything from national parks to meat inspectors) versus defense spending. There is also a question about duration of the spending caps: Democrats want two years; Republicans have argued for 10.
Overall, we believe policymakers will find common ground that likely results in few, if any, near-term cuts to spending, but will produce longer-term deficit savings relative to the CBO’s current projections. Of course, to really tackle the fiscal sustainability of the country, policymakers would have to address the elephant in the room – entitlement spending – but that is a non-starter politically on both sides of the aisle for the foreseeable future.
When, realistically, do lawmakers need to reach a deal? Everyone is working toward the Treasury’s June 1 X date. To meet that deadline, negotiators likely need to reach a high-level deal by the middle of this week in order to craft legislative text and then proceed with House and Senate procedure. Once a deal is reached in principle, there may be further drama around garnering sufficient support for the deal among rank-and-file members, but we believe there will be sufficient support on both sides of the aisle to get a bill passed. Also, if Congress needs additional time to negotiate or to put pen to paper, it’s possible we could see a short-term extension of one or two weeks at most.
We don’t expect invocation of the 14th Amendment. Lately there has been more noise about President Joe Biden’s possible use of the 14th Amendment to effectively ignore the debt limit, citing the clause that public debt 'shall not be questioned.' However, Treasury Secretary Janet Yellen continues to insist that the only way the debt ceiling can be addressed is through Congress. From a market perspective, the amendment approach seems unlikely given the uncertainty it could cause, and it also seems unlikely from a political perspective, given the expected blowback.
Market reaction: If past debt ceiling situations are prologue, equity markets may wobble this week depending on the course of negotiations, but assuming the anticipated deal crystallizes and there is no default, markets could likely retrace after a resolution. There was an exception in 2011, when equity markets continued declining after the resolution and X date, partly due to the European debt crisis and partly due to the anticipation of large spending cuts that were part of the resolution. With that said, we have already seen significant dislocations in the fixed income market, creating both risks and opportunities.
Bottom line: While it will likely be a noisy next few days or week, we remain constructive on a deal coming together before the June 1 X date, with an outside possibility of a short-term extension (measured in weeks, not months). As a result, lawmakers (and markets) probably would not have to contend with the debt ceiling again until 2025, after the highly anticipated 2024 elections. No one seems to have the political incentive to compromise until the last minute, so we may see some pain and drama leading up to next week’s deadline, but the overall outcome appears clear to us: A debt ceiling resolution will pass.