Political risks and fiscal cliffs
Trade tensions have dominated the discussion in recent months and will remain a large concern for markets in the second half of this year. That said, we see several other concerns likely to hit the headlines including the budget, the debt ceiling, and election campaigning. We believe that the debt ceiling stand-off is the most dangerous of these risks. A “worst-case scenario” is highly unlikely to materialize, but partisanship is likely to cause market concerns.
How are budget battles and the debt ceiling related?
The budget and the debt ceiling are closely related. The amount of U.S. debt outstanding is determined by how quickly it spends (budget) relative to how quickly it gains income (tax revenue). The debt ceiling is the legal limit on the total amount of federal debt the government can accrue. The issues can be resolved separately but have also been discussed as a part of the same deal. In late 2013, for example, we had a budget battle that led to a shutdown and a simultaneous debt ceiling increase.
This time around we face a possible shutdown, debt ceiling increase, and automatic spending cuts (sequestration) should Congress fail to act. The current U.S. budget includes spending agreements that take us into October. If Congress chooses not to lift the debt ceiling, they will have to either:
- Adapt the budget to avoid accruing any additional debt. In this case, we would likely see strong infighting in Congress as to what would get cut. From time to time, budget battles result in a government shutdown to reduce costs. While this is possible in the second half of the year, it is unlikely to solve the impending debt ceiling challenge. Shutdowns, including the longest one earlier this year, do not generally have a material impact on economic activity or financial markets. For furloughed workers, it creates a cash flow problem, but for most of the country, it is mostly an inconvenience.
- Continue to accrue debt and enter a technical default.
The U.S. Treasury officially exceeded its debt ceiling in March of this year. The Treasury can use “extraordinary measures” to pay the bills for a while, but this can fluctuate based on real-time tax receipts and spending.
If the U.S. Congress does not raise the debt ceiling by that time, then the U.S. would enter a technical default. This would be extremely disruptive for financial markets in the U.S. and asset pricing globally. Read more in our outlook.
What will happen?
We believe that both the budget and debt ceiling issues will be resolved, the government will not be shut down, and a sequester (proportional budget cut) will not kick in. A “grand bargain” is unlikely, but not out of the question. Instead, we believe that continuing resolutions are far more likely. While this is a favorable result, the process around the debt ceiling is likely more important than the outcome. Partisan politics could create meaningful volatility before any agreements are reached.
Change in VIX Index ahead of debt ceiling
Source: New York Life Investments Multi-Asset Solutions team, Bloomberg, CBOE, 7/15/19. Past performance is no guarantee of future results. It is not possible to invest directly in an index. The CBOE Volatility Index (VIX) is a measure of expected price fluctuations in the S&P 500 Index options over the next 30 days. The VIX, often termed as the “fear index,” is calculated in real time by the Chicago Board Options Exchange (CBOE).
2011 was characterized by a particularly toxic bout of political infighting coinciding with the European Union (EU) debt crisis. U.S. Equity markets fell more than 20%, and rating agency, Standard & Poor’s, downgraded the U.S. debt rating. The Federal Reserve implemented Operation Twist in September 2011, in part, to offset the effects of the debt ceiling fight. Not surprisingly, the Fed looks prepared to cut interest rates later this year, should growth slow due to fiscal or trade policy.
Since the debt ceiling was established in 1917, Congress and the President have increased its level roughly 100 times. In this expansion alone, lawmakers have increased or modified the debt limit ten times. Still, the nature of these political battles could increase the perceived risk of a U.S. rating downgrade.
What is the timing?
The last legislative day before Congress heads out for a six-week summer recess is July 26th. Treasury Secretary Mnuchin is trying to stir the pot by suggesting that it is possible the Treasury could exhaust all emergency measures prior to their return in mid-Sept to push Nancy Pelosi into doing a deal now. We think it’s most likely that we see lots of headlines over the next two weeks before a quiet August and ramp up in September. However, if the debt ceiling becomes threatening more quickly, Congress can be called back from recess in August.
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Operation Twist is the name given to a Federal Reserve monetary policy operation that involves the purchase and sale of bonds. The operation describes a monetary process where the Fed buys and sells short-term and long-term bonds depending on their objective.
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