There is a famous 1972 kid’s book called Alexander and the Terrible, Horrible, No Good, Very Bad Day. The title, at least, seems to have become the playbook for the debt ceiling debacle currently unfolding far too slowly.
Examining best guesses on potential outcomes is the closest thing to scenario planning possible. There are two broad categories: President Biden and House Republicans secure a deal, or they don’t.
The most optimistic view, the first one, isn’t totally out of the question. On Thursday, House Speaker Kevin McCarthy said he can “see the path” to an agreement, according to multiple sources. “I think we have a structure now.” The hardline House Freedom Caucus wants no deal without a collection of heavy and weighted budget cuts, a measure called the Limit, Save, Grow Act, which Senate Majority Leader Chuck Schumer said wouldn’t have a hope of passing in the Senate.
But assume for a moment that something passes and there’s an increase to the debt ceiling. As Bloomberg reported, some experts like Ari Bergmann, founder of strategic and risk management advisory firm Penso Advisors think there will be pain even in a deal.
The problem is timing. A last-minute resolution, and that is the only type possible now, would leave the Treasury like a person who had been trapped underwater and suddenly broke surface, gasping. Only the air needed in this case would be cash.
“My bigger concern is that when the debt-limit gets resolved — and I think it will — you are going to have a very, very deep and sudden drain of liquidity,” Bergmann told Bloomberg. “This is not something that’s very obvious, but it’s something that’s very real. And we’ve seen before that such a drop in liquidity really does negatively affect risk markets, such as equities and credit.”
A fast run of Treasury bond issuance to pull in needed cash will pull liquidity out from everywhere else, driving up rates because government demand would outstrip the normal supply of cash. That could pull bank reserves, forcing the Federal Reserve to moderate quantitative tightening, changing the dynamic of fighting inflation.
Separately, the Secured Overnight Financing Rate (SOFR), which drives a lot of lending calculations, would rise because Treasury yields would rise, pushing down the value of already existing government bonds. That means refinancing CRE loans would become even more expensive than it is now.
“That’s directionally correct,” Arkhouse managing partner Gavriel Kahane tells GlobeSt.com. “That’s if it gets solved. I think the overwhelming likelihood it will.” But, as he says, “it will be the last second of the last minute of the 11th hour.”
Again, that’s the positive outcome.
Regarding a default, Moody’s Analytics sees two scenarios. One is a short-term breach. The initial reaction: “financial markets will be roiled” as they were when in 2008 Congress didn’t initially pass the Troubled Asset Relief Program banking bailout. Interest rates would spike and equity values would plunge. Short-term funding that is the oil for credit markets would likely seize up.
While Moody’s Investors Service thought that the U.S. credit rating would remain close to Aaa, “Standard & Poor’s downgraded the nation’s debt in the 2011 debt limit battle for much less, citing the political dysfunction at the time. Since then, that dysfunction has only intensified,” Moody’s Analytics wrote. However, a “downgrade of Treasury debt would set off a cascade of credit implications and downgrades on the debt of many other financial institutions, nonfinancial corporations, municipalities, infrastructure providers, structured finance transactions, and other debt issuers.”
“I think faith in the system would be forever impaired,” Kahane says. “But I guess investors have a short memory. An analog in real estate is that there are plenty of developers that have gone bankrupt or defaulted and five years later they’d back at it. The market will give our government credit once again even after default.” If the result was a loss of faith for everyone, the U.S. “might still be sitting at the front of the class” because of relative strength.
The worst outcome would be a prolonged breach.
“The blow to the economy would be cataclysmic,” Moody’s writes. “The federal government would have no option but to slash its outlays, since outlays could be no greater than revenues the Treasury collects. Assuming a June 8 debt limit breach that dragged on through July, the Treasury would have no choice but to eliminate a cumulative cash deficit of approximately $150 billion by slashing government spending. As these cuts work through the economy, the hit to growth would be overwhelming.”
The impact on faith among consumers, businesses, and investors would be beyond easy measure. “It is difficult to envisage what steps policymakers could take to mitigate the economic carnage.”