Understanding The U.S. Debt Ceiling - The Looming Showstopper
By Nicholas Puri and Lorenzo Beriozza
With President-elect Trump's inauguration fast approaching, public speculation regarding what his term will actually entail is arguably higher than any other presidential tenure in recent memory. The back and forth discussions of "will he", "won't he" have created division, disagreement and insecurity.
On the other hand, if you observe US assets, the assumption is much more binary. Trump's rhetoric has all been focused on putting "America first", investing heavily in the nation's infrastructure and accelerating economic growth. Taking this at face value means high levels of domestic spending can be expected, which can only be a positive for US assets. The markets have indeed responded in kind.
However, when you look at the realities of the situation, you may wonder under what pretense the markets are behaving so exuberantly. It is undeniable that an investment in the country's infrastructure of nearly $1 trillion, as suggested by Trump, has the potential to be a very positive boost for the economy. The confusion arises when you question where these dollars will come from and at what cost.
Trump suggested in his campaign vision that this infrastructure investment would be achieved in a deficit-neutral manner. While this would be an admirable achievement, it does not seem a likely possibility. When you also consider his promises of tax cuts, which Republicans such as Paul Ryan have suggested will be revenue neutral, this means there would need to be reductions made in government spending not increases.
The alternative is, of course, to achieve the infrastructure investment through further deficit spending. However, this brings us onto the most important obstacle to this situation and one of the biggest issues President Trump will be facing during his first year in office: the impending "debt ceiling" deadline. As has been proven in recent years, the market neglects this matter at its peril.
What is the US debt ceiling?
The "debt ceiling" (or debt limit) is the total amount of money the government is authorised to borrow to pay its legal obligations. This includes commitments such as social security benefits, Medicare, military expenditure and interest payments on national debt.
The US Constitution specifies that the "power of the purse" is entrusted to Congress. This gives it the ability to control spending and borrowing, therefore also making it responsible for authorising bond sales made by the Treasury and assigning the total limit on this. The current obligations include approximately €13 trillion of debt owed to bondholders and €5 trillion of debt owed to government accounts such as social security and Medicare trust funds.
The existing debt ceiling is set to expire on 15 March, 2017, at which point an array of severely negative market effects will take place, as well as harmful impacts on the US reputation and confidence. To avoid this, the newly appointed Congress will be required to work immediately in Q1 2017 to increase the limit and avoid any potential disasters from taking place.
It is important to note that the debt limit increase is solely to permit the government to meet its existing obligations; it does not authorise new spending. The Federal budget, which determines government spending, is due to be approved by Congress by 15 April, 2017, and will take effect in the new fiscal year starting on 1 October.
Will this really be an issue?
Raising the debt ceiling has predominantly been a non-event since its introduction, with it being increased periodically without much friction. However, in recent years, this has become a highly partisan point of discussion, with both sides of the aisle attempting to introduce additional requirements to the bill and increasingly being unwilling to compromise.
Of particular note in recent years was the public struggles between President Obama and the Republican-controlled Congress. This began in 2011 and culminated in a highly problematic government shutdown in 2013. Although the shutdown was short-lived, it highlighted the severe repercussions that exist if a steadfast agreement is not made in a timely manner.
Eventually Congress agreed to extend the existing debt ceiling until 15 March 2017, an action that was labelled by many as "kicking the can down the road". Unfortunately the problem will now need to be addressed immediately by President Trump, although a similar solution is likely to take centre stage.
Considering the promises Trump has made regarding public spending, this discussion will be a delicate matter and will determine how far Trump's plans for investment will go in his first term. However, as the new president is likely to enjoy the benefits of having at least a marginally more supportive Congress than President Obama, a deal seems to be somewhat more likely.
Nevertheless, these discussions will not be without issue and any compromises that are made may not be entirely to Trump's satisfaction, considering his elaborate plans. A notable portion of influential Republicans have long been opposed to any increases in the debt limit, without restrictive changes being made in the budget to curtail spending.
Although president-elect Trump has not been explicit about his approach to the impending debt ceiling issue, his actions regarding his cabinet may provide a clue. In particular, his nomination of South Carolina rep. Mick Mulvaney for Director of the Office of Management and Budget is intriguing.
Mulvaney has no specific expertise on any budget committee, but has expressed controversial views in the past regarding the debt ceiling. Not only did he vote against the deal that was reached in 2011 to avoid the Fiscal Cliff, but he has also stated his opposition to the need for periodic increases in the limit. It is also worth noting that in the last vote on the debt limit in 2015, the deal was supported by 79 Republicans and opposed by the majority of 167; the deal was passed predominantly due to the backing of Democrats.
What are the likely next steps?
If the limit is not increased by March 2017, which would be considered a fast turnaround based on recent similar events, the US would immediately be in violation of the debt ceiling. At this point, the Treasury will need to enact its "extraordinary measures" to avoid defaulting on its debt obligations.
These extraordinary measures would include halting contributions to government pension funds and reassigning certain funds that are issued by state governments. This may give the Treasury additional room to manoeuvre until the middle of the summer. Although any actions taken to delay payment defaults are likely to cause panic in the markets and concern from the public, as we witnessed during the Fiscal Cliff discussions and throughout 2013.
In addition to this, if an agreement does not take place before March, the Treasury's cash balance will need to decrease dramatically. The resulting reduction in US Treasury bills being supplied to the market is likely to cause a further increase in volatility, therefore compounding any concern and investor troubles.
While the market continues to experience exuberant optimism regarding US assets, it may be time to throw some caution to the wind and monitor the developments of this impending situation.
It would be unwise to suggest preempting a correction and attempting to profit from a reversal of the post-Trump rally simply based on the expectation of difficult fiscal discussions taking place. After all, even if discussions did hit a stumbling block, as Keynes famously stated: "the markets can stay irrational longer than you can stay solvent". However, it is certainly a situation and potential issue that any investor with exposure to the US should be keeping a close eye on in the coming months.
See also Non-OPEC Voluntary Cuts Unraveling Before They Even Start on seekingalpha.com