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Prior US debt ceiling showdowns have been resolved in time to avoid a default, is this time different?
We estimate a selective default is in the range of a 33%-50% chance of occurring.
We think the US will avoid interruption of principal and interest, and presumably avoid a default event in US Treasurys.
US debt ceiling negotiations
The US Treasury is currently limited on how much debt it can issue due to a federal law capping that amount. Given persistent budget deficits, this debt limit must be periodically raised by Congress so the US Treasury can continue to fund ongoing government expenditures. At some point, without the ability to issue additional debt, the US would be unable to pay expenditures otherwise authorized by Congress, potentially including repayment of principal and interest on existing US Treasury debt. For over a decade, Republicans have sought to use the need to raise the debt limit as a bargaining chip to obtain spending cuts to the US budget. Democrats have historically been unwilling to make such spending concessions, instead daring Republicans to force a default by the US government; a classic game of “chicken”.
In the past, Republicans have decided each time to raise the debt limit without obtaining any spending concessions, thereby avoiding a US default. Presumably, this is what will happen again. Although this time, the Republican Speaker of the House, Kevin McCarthy, has far less control over his caucus than past speakers. To obtain his gavel last year, he had to win over a large swath of far-right holdouts within his caucus. To do this, he agreed to allow any single member of his caucus to prompt a vote of “no confidence” challenging his speakership. Furthermore, because many in his caucus have never voted to raise the debt ceiling, the Speaker’s ability to negotiate effectively is limited. Said another way, if Kevin McCarthy were to allow the debt ceiling to be raised without spending cuts, it very well could be the last thing he does as Speaker of the House of Representatives.
For this reason, we believe the odds of some form of selective default by the US government is much higher now versus previous occasions. Although difficult to handicap, we estimate a selective default is in the range of a 33%-50% chance of occurring.
When the US government will run out of money is a now a function of how much tax revenue it receives in the coming months. Recent estimates suggest the US government may be forced into some form of default as early as June with the potential to occur in July or August, or even as late as September, depending on how tax receipts evolve. Secretary of the Treasury recently sent a letter to Congress indicating there is a substantial risk this “X-Date” could come as early as June 1, although the exact timing of when the Treasury runs out of money remains unclear.
We believe the odds of some form of selective default by the US government is much higher now versus previous occasions.
Implications of selective default of US Treasury debt payments
As far as what a selective default would look like, there are a couple of factors in play here, the first of which is the 14th Amendment to the Constitution, which states: “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned…”
We believe this would provide ample constitutional cover to allow/require the US Treasury to continue to pay principal and interest on existing US Treasury debt. However, the US Treasury could withhold all payments that are not debt related. These other payments would include Social Security benefit payments, Medicare/Medicaid payments, wages to government employees (including members of Congress, TSA employees, members of the armed forces, etc.), tax refunds, and payments to government contractors. Because the US government would still be collecting taxes, it should have sufficient ability to cover interest payments and roll existing maturities, thereby avoiding any interruption of principal and interest, and presumably avoiding a default event in US Treasurys.
So even if the Biden administration does not explicitly attempt to invalidate the debt limit as unconstitutional based on the 14th amendment, our base case for any default by the US government is the Treasury would withhold payments on non-debt obligations.As a result, we view the risk of any interruption to scheduled payments of principal or interest on US Treasury securities as extremely low.
Given a large portion of outstanding US Treasurys is held by foreign governments, such an approach by the US Treasury also implies the US government will be paying foreign nations like China before it pays its own people. It’s highly unlikely this will go over well with the average person in the US. This should, in turn, spur Congress to action and make such a selective default very short-lived.
Market implications
Treasury bills (T-bills) are often a canary in the coal mine for the rest of the market related to both risk and timing of a potential default. In past debt ceiling showdowns, investors have avoided T-bill maturities surrounding those periods with the highest risk of payment interruptions. Last week’s US Treasury auction of 1-month T-bills maturing June 4, 2023, cleared at a yield of 5.84%, whereas 2-month T-bills cleared at 5.40%. This strongly suggests investors are growing increasingly worried about the potential for a default.
Historically, the possibility of a US default not only impacted T-bill maturities around potential default dates, but also prompted a modest flight to quality. This resulted in equities selling off, Treasury yields lower, and investment grade/high yield spreads wider. We expect something similar this time around, with volatility potentially higher than in the past, much more so if the US Treasury is forced into some type of selective default (i.e., halting non-debt expenditures).
This material is provided by Aegon Asset Management (Aegon AM) as general information and is intended exclusively for institutional and wholesale investors, as well as professional clients (as defined by local laws and regulation) and other Aegon AM stakeholders.
This document is for informational purposes only in connection with the marketing and advertising of products and services, and is not investment research, advice or a recommendation. It shall not constitute an offer to sell or the solicitation to buy any investment nor shall any offer of products or services be made to any person in any jurisdiction where unlawful or unauthorized. Any opinions, estimates, or forecasts expressed are the current views of the author(s) at the time of publication and are subject to change without notice. The research taken into account in this document may or may not have been used for or be consistent with all Aegon AM investment strategies. References to securities, asset classes and financial markets are included for illustrative purposes only and should not be relied upon to assist or inform the making of any investment decisions. It has not been prepared in accordance with any legal requirements designed to promote the independence of investment research, and may have been acted upon by Aegon AM and Aegon AM staff for their own purposes.
The information contained in this material does not take into account any investor's investment objectives, particular needs, or financial situation. It should not be considered a comprehensive statement on any matter and should not be relied upon as such. Nothing in this material constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to any particular investor. Reliance upon information in this material is at the sole discretion of the recipient. Investors should consult their investment professional prior to making an investment decision. Aegon Asset Management is under no obligation, expressed or implied, to update the information contained herein. Neither Aegon Asset Management nor any of its affiliated entities are undertaking to provide impartial investment advice or give advice in a fiduciary capacity for purposes of any applicable US federal or state law or regulation. By receiving this communication, you agree with the intended purpose described above.
Past performance is not a guide to future performance. All investments contain risk and may lose value. This document contains "forward-looking statements" which are based on Aegon AM's beliefs, as well as on a number of assumptions concerning future events, based on information currently available. These statements involve certain risks, uncertainties and assumptions which are difficult to predict. Consequently, such statements cannot be guarantees of future performance, and actual outcomes and returns may differ materially from statements set forth herein.
The following Aegon affiliates are collectively referred to herein as Aegon Asset Management: Aegon USA Investment Management, LLC (Aegon AM US), Aegon USA Realty Advisors, LLC (Aegon RA), Aegon Asset Management UK plc (Aegon AM UK), and Aegon Investment Management B.V. (Aegon AM NL). Each of these Aegon Asset Management entities is a wholly owned subsidiary of Aegon N.V. In addition, Aegon Private Fund Management (Shanghai) Co., a partially owned affiliate, may also conduct certain business activities under the Aegon Asset Management brand.
Aegon AM UK is authorised and regulated by the Financial Conduct Authority (FRN: 144267) and is additionally a registered investment adviser with the United States (US) Securities and Exchange Commission (SEC). Aegon AM US and Aegon RA are both US SEC registered investment advisers.