Debt Ceiling Fight Starting to Take Toll on Markets

A view of the U.S. Capitol in Washington on Oct. 6, 2021. (Drew Angerer/Getty Images)

As the White House and top Republican lawmakers are stuck at an impasse over the debt ceiling, the cost of insuring exposure to U.S. government debt has touched record highs.

Spreads on 1-year credit default swaps (CDS), a market-oriented measurement of default risks, climbed to a record high of 172 basis points on May 10. Spreads on 5-year CDS also reached a 12-year high of 65.3 basis points.

CDS are financial instruments used to enable lenders to insure against default by borrowers. Investors owning government bonds, bank credits, or corporate debt can purchase credit-default swaps to shield their investments against default and allocate these risks to sellers. Traders can also use CDS for speculative bets.

But some market observers note that the CDS market may also be monitoring monetary policy and inflation levels.

“Investors may be tracking the CDS market for clues about the possibility of U.S.-government default, but our analysis indicates that spreads could also change for noncredit reasons such as shifts in Federal Reserve policy or unexpectedly high (or low) inflation,” said Andy Sparks, the managing director at MSCI Research, and Michael Wang, an associate at MSCI Research, in a report.

That said, even the current administration is taking notice of developments in the financial markets, warning that these “market-stress indicators” could exacerbate the closer the U.S. reaches its debt ceiling deadline.

“The cost of insuring U.S. debt has also risen substantially and is now at an all-time high, reflecting increased worries about a U.S. default,” the White House wrote. “In fact, credit default swap (CDS) spreads—the insurance premiums that must be paid to insure U.S. debt—started to increase dramatically in April.”

Treasury Secretary Janet Yellen listens during an open session of a Financial Stability Oversight Council meeting at the Department of the Treasury in Washington on April 21, 2023. (Alex Wong/Getty Images)

Treasury Secretary Janet Yellen recently stated in a letter to House Speaker Kevin McCarthy (R-Calif.) that the U.S. could default as early as June 1 if Congress fails to act. Since the federal government reached its debt limit of $31.4 trillion earlier this year, it had been estimated that Washington would hit the so-called X-date between June and September. However, due to lower-than-expected tax receipts—30 percent below revenues from the same time a year ago—additional analyses are supporting Yellen’s forecast.

Moody’s Analytics anticipates the X-date will occur on June 8, earlier than the Aug. 18 expectation in the previous report in March.

Whatever the date may be, Shai Akabas, the director of economic policy at the Bipartisan Policy Center, thinks policymakers are playing a game of Russian Roulette with the U.S. economy.

“If a solution is not reached before June, policymakers may be playing daily Russian Roulette with the full faith and credit of the United States, risking financial disaster for their constituents and the country,” said Akabas in a statement. “Even now, the looming deadline is raising costs to the government, and therefore to all taxpayers.”

A planned May 12 meeting between President Joe Biden and McCarthy had been postponed. The two sides are now expected to meet early next week.

Moody’s believes that officials might only act if there is a selloff in stocks and bonds and the value of the U.S. dollar craters and “donors and constituents, angry at their evaporating wealth, pound on lawmakers’ doors.”

Donald Trump Joins the Debate

Former President Donald Trump weighed in on the debt ceiling debate, urging GOP lawmakers to let the U.S. default on its debt if Democrats do not agree to “massive cuts.”

“I say to the Republicans out there—congressmen, senators—if they don’t give you massive cuts, you’re going to have to do a default,” said Trump during a CNN town hall on May 10. “And I don’t believe they’re going to do a default because I think the Democrats will absolutely cave, will absolutely cave because you don’t want to have that happen. But it’s better than what we’re doing right now because we’re spending money like drunken sailors.”

Trump, a frontrunner for the Republican nomination in the 2024 election, asserted that the U.S. might as well default now “because you'll do it later.”

Former President Donald Trump speaks at a CNN Town Hall with CNN’s Kaitlan Collins at St. Anselm College in Manchester, N.H., on May 10, 2023, in a still from video. (CNN/Screenshot via The Epoch Times)

Last month, the House voted 217-215 to raise the nation’s debt ceiling. McCarthy’s proposal would return discretionary spending to 2022 levels and cap future spending increases at 1 percent.

The real estate billionaire mogul is no stranger to the debt ceiling.

In 2019, the former president announced a two-year budget agreement and debt-ceiling increase. Trump argued that the debt ceiling should never be used as a bargaining chip because it is “a sacred element of our country. They can’t use the debt ceiling to negotiate.”

Meanwhile, in response to the former president’s recommendation, Yellen told reporters ahead of the meeting of G7 finance ministers and central bank governors in Japan that “America should never default.”

“The notion of defaulting on our debt is something that would so badly undermine the U.S. and global economy that I think it should be regarded by everyone as unthinkable,” Yellen explained to reporters. “There is no good alternative that will save us from catastrophe. I don’t want to get into ranking which bad alternative is better than others, but the only reasonable thing is to raise the debt ceiling and to avoid the dreadful consequences that will come.”

The former head of the Federal Reserve also suggested that the U.S. government needs to end these repeated standoffs over the debt ceiling and “find a different system for deciding on fiscal policy.”

Despite the catastrophic warnings of not raising the debt limit, Trump noted during the town hall that “it’s really psychological more than anything else.”

“It could be very bad. It could be, maybe, nothing,” he said. “Maybe it’s—you have a bad week or a bad day, but, look, you have to cut your costs.”

Many leaders have conceded that the national debt projected in the recent White House’s 2024 budget to reach nearly $51 trillion by 2033 is on an unsustainable path.

In the first seven months of the fiscal year, the U.S. government has run a $925 billion budget deficit, according to the latest Monthly Treasury Statement.

“Deficits are clearly on the rise; in the last 12 months, we’ve borrowed $925 billion. No one should think that this kind of borrowing, particularly when unemployment is at a 50-year low and inflation at a 40-year high, is sustainable,” said Maya MacGuineas, president of the Committee for a Responsible Federal Budget (CRFB), in a statement.

Doom and Gloom?

If the debt ceiling is not increased, Washington officials would be forced to operate the federal government on a cash-flow basis. This means that outflows would need to be paid for by inflows, forcing everyone to prioritize payments.

The consensus is that not raising the debt ceiling would trigger a deep recession, increase interest rates, cost millions of jobs, and tank the stock market. The nation’s long-term growth prospects would also be impaired, experts warn.

However, because default has not occurred in the modern economy, “it remains uncertain as to exactly what developments would transpire next,” Fidelity noted.