Debt ceiling | Wells Fargo Investment Institute (2023)

• To be clear, our base case remains a near-term agreement by Congress to raise the debt ceiling.
• In our view, the debt ceiling is the most important as it represents another short-term uncertainty and a possible source of austerity measures that would deepen a mild recession and reduce the liquidity available to the market.

• Conversely, we expect a recession and reduced liquidity to lead to market volatility, reinforcing our preference for a defensive portfolio positioning.

1. Is there flexibility on the US Treasury X-Date?

On May 22, Treasury Secretary Janet Yellen continued to warn policymakers that the US Treasury will likely run out of cash by early June and that the X-date could be as late as June 1st.

Disappointing tax receipts and rising interest costs combined to push the X date forward from the Treasury Department's earlier estimate of July or even August. Income from capital gains was below the Treasury Department's earlier forecast. Expedited filing of larger-than-expected refunds is also impacting revenue, as are weather-related delays in tax deadlines in California, Alabama and Georgia through mid-October 2023.

2. How long will it take for Congress to pass a debt ceiling increase once agreement in principle is reached, and what are the problems?

In 2011, congressional leaders agreed in principle over the weekend to a deal that went into effect two days later. Since then, the House of Representatives has passed a rule mandating a 72-hour reading time between when a bill is introduced in the House of Representatives and when it is voted on. There are also procedures in the Senate that can last for days. Luckily, every chamber of commerce has programs that can speed up the process significantly. We don't think it's out of the question that a deal and the president's signature will be in place before the early June deadline.

In particular, the President wants to extend the debt ceiling to give the Treasury Department enough leeway for 2025. The House of Representatives is poised to raise the debt ceiling but wants to cut spending on a dollar-for-dollar basis. Two open issues already on the table could form the basis for a compromise. First, the cancellation of unspent federal COVID funds can be counted as an expense. Second, the parties can compromise on the job requirements for certain types of federal assistance. The third reform of the licensing process for fossil fuel extraction appears to be anything but a compromise.

3. How can Congress increase the time it takes to draft a debt ceiling agreement?

A short-term debt moratorium is the most obvious way to buy the government time to widen the debate on the debt ceiling. If a short-term deal is reached, the delay could last several weeks, allowing any pay rises to go through the legislative process, or it could be discussed longer and more fully when the government's fiscal year ends in September. 30

Invoking the 14th Amendment (essentially stating that the validity of legal government debt should not be called into question) to restore government debt seems unlikely, as such an interpretation raises constitutional issues that could lead to lengthy legal challenges. However, the government could find a stronger legal basis if it uses the change to prioritize government interest payments. That could be a course of action if Congress can't reach an agreement before the Treasury Department runs out of money.

Several other alternatives that we think are less likely include the Treasury minting a $1 trillion platinum coin, or using high-quality government bonds with interest rates high enough to boost government revenues, since bidding is low bond auctions are higher.

4. Will interest on existing debt be paid during a technical outage?

The US Treasury Department may prioritize principal and interest payments on existing debt over other expenses to avoid a technical default. When there is a delay in interest payments, the Securities Industry and Financial Markets Association (SIFMA) believes that “Default interest does not accrue. However, reimbursement rates may be published, but these will most likely differ from the rates on the coupon.”¹While the exact form of compensation is unclear, we expect there will be some form of interest compensation for late payments.

There is precedent for this situation. In 1979, payment processing problems caused delays in interest payments on certain Treasury bills.²After some lawsuits and new laws, the Treasury grants additional benefits to investors.

5. What is the potential market impact of a technical failure?

Volatility is likely to increase as Congress drags on and investors grow concerned about a technical default. We believe most government bond yields are likely to fall, although government bond yields maturing in the coming weeks (around the X date) could rise significantly. We also expect credit spreads to widen, credit default swaps to rise and the dollar to weaken. The stock market will likely view any technical failure as risk aversion and could fall until a clear resolution is found.

Some US Treasuries maturing in June have lost some value as the Treasury moved the X date forward. In our view, as long as there is an impasse on the debt ceiling, most investors will likely consider holding government bonds maturing between now and July. We believe that investors will ultimately be fully rewarded and their principal and interest recouped once the debt ceiling is raised. Still, investors with short-term liquidity needs should consider whether they can tolerate late payments. Investors who need access to the funds by a certain date may need to consider selling securities.

In terms of stocks, the S&P 500 lost about 18% between July 20, 2011 and October 3, 2011 after a debt ceiling agreement was reached this year. Interestingly, most of the losses in this decline occurred during the yearreturnAn agreement was reached in 2011. The deal came with better-than-expected austerity measures and investors lowered their growth forecasts. The significant impact on the market may not be thereIfAn agreement will be reached - as we expect an agreement to be reached at some point - but whether the details of the agreement will have a major impact on market expectations.

6. How are money market funds affected when the risk of default increases?

The impact of a technical failure on money market mutual funds (MMFs) is complex, particularly operational. However, we do not believe that in the event of a technical failure, money market funds will be forced to liquidate their US Treasury holdings. Current regulations do not oblige money market funds to liquidate defaulted securities and the criteria for evaluating funds include provisions that allow fund managers a reasonable time to dispose of defaulted securities.³

Money market funds may face an increased risk of outflows as investor concerns grow. However, we believe most of them are well positioned to process redemptions. Money market funds that have access to the Fed's liquidity facility can invest in overnight repos and liquidate positions to meet redemption needs. Treasury money market funds that can't invest in repos may need to hold more cash with their custodians or avoid debt maturing near the X-date.

7. Is another US Treasury rating downgrade likely? What does this mean for fixed income pricing?

In the event of a technical failure, we believe rating agencies are likely to downgrade their ratings. The near-term impact will be less pronounced as US Treasuries are still seen as a safe haven. We expect government bonds to recover during these times of risk aversion (declining yields and rising prices). However, problems could arise at some point if investors demand increased interest in US Treasuries and demand from foreign investors could change, which could affect upcoming auctions. Overall, this is negative for fixed income pricing as US Treasuries are considered risk free and thus the basis for fixed income pricing.

8. What should stock investors do?

We tend to focus on longer-term factors affecting relative performance, such as the economic cycle, Fed policy or interest rates, rather than short-term volatility. Even in 2011, the S&P 500 didn't hit a new high until February 22, 2012, after the 18% drop mentioned in question 5. Investors have turned their attention back to the economic recovery and the generally positive earnings environment.

We have maintained a defensive equity position since early 2022 as risk increasingly appears to outweigh potential gain. While the S&P 500 is up 9.64% so far this year (to May 22), gains have been concentrated in just a handful of big tech companies. Over the same period, the equally weighted S&P 500 gained just 1.23%. While equities are trading at the high end of the recent debt ceiling trading range, we favor reducing exposure ahead of our expected recession, particularly in lower quality areas.

9. How might different debt ceiling solutions exacerbate or mitigate a protracted economic downturn?

The austerity measures associated with the above trade-offs are expected to result in a mild recession this year. Even without the short-term debt ceiling agreement, the deficit is already more than 12% of forecast revenue, and the trend is rising. As we recently noted, interest payments in excess of 14% previously triggered tightening.⁴Even if Congress doesn't include spending cuts in the debt ceiling deal, rising interest burdens could push bond yields higher and prompt Congress to cut spending or raise taxes, cuts that could be similar to the cuts currently being negotiated.

Beyond the direct economic impact of spending cuts and tax increases, higher interest rates impact government spending, housing, and other interest-rate-sensitive sectors of the economy. The growth could be driven by higher risk premia on sovereign debt related to technical failures or even the chaotic negotiations that led S&P to downgrade the sovereign debt in August 2011. The government could soften the aftermath of the debt ceiling deal by postponing tax and spending changes, essentially extending the adjustment period to reduce the deficit.

10. We view the debt ceiling as a US issue, but some leaders have warned of its global implications. If concerns about a possible US default increased, what would be the possible global implications?

Even short-term disruptions in the payment of Treasury interest and debt can affect the smooth flow of global funding and the pricing of other securities in the United States and abroad. The role of US Treasuries as a risk-free benchmark means that distortions in US Treasury pricing caused by disruptions in debt payments will impact the rest of the global bond market and potentially affect issuance and trading of legacy securities .

Disruptions in the US Treasury market will also have a more immediate impact on market liquidity, in our view, as they are used as collateral for global repurchase agreements and other financing transactions.

Debt defaults can also increase sector spread rates by creating a risk premium on government bonds, thereby raising benchmark interest rates on other securities based on the US Treasury benchmark. A second traditional rating agency (Moody's or Fitch) is downgrading government bond ratings, which could firm up the government bond risk premium, making the AA+ government bond rating a widely accepted rating in the global bond market.

Over the longer term, the precedent of default and its consequences reinforce the case for diversification of the dollar as the dominant currency in world trade and finance.

¹SIFMA, May 2023. Late Payments to Treasury: Discussion of Scenarios and Scripts. page 7

²"The Day the United States Defaulted on Treasury Bills," Terry Zivney and Richard Marcus, Financial Review, Vol. 24, No. 3, August 1989.

³In accordance with Rule 2a-7 of Part 270, Chapter II, 17 CFR, in respect of money market funds, the Fund must hold at least 10% of its total assets in daily cash and at least 30% in weekly cash. See Electronic Code of Federal Regulations.

⁴See Investment Strategies Report, “Managing Volatility Around the Debt Cap Debate,” May 15, 2023.

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