US politicians will raise the debt ceiling, but will they get the timing right?

This means an agreement to raise the ceiling needs to be reached within the next two months to avoid a technical Treasury default.

In the wake of these concerns, Republican Speaker of the House Kevin McCarthy introduced the Limit, Save, and Grow Act of 2023 last week. The bill proposes to raise the current debt ceiling by US$1.5 trillion, or suspend it through to March 31, 2024, whichever comes first, while proposing US$4.5 trillion in savings from key Biden administration priorities.

In addition to limiting fiscal spending, McCarthy’s bill also proposes removing clean energy tax credits approved in the Inflation Reduction Act and enacting the Republican proposal to expand domestic energy production. Another further contention is the proposal to have major agency rules approved by Congress rather than through executive orders.

It was widely acknowledged that raising the government debt limit was going to be an arduous task amid the political stalemate between Democrats and Republicans. Given the caveats within the proposed bill, it seems unlikely that an agreement can be reached immediately.

That said, assuming an orderly and rational discussion can be facilitated, a compromise should be reached ahead of the deadline. The Democrats and Republicans hold contrasting views on a wide range of issues, including fiscal spending and energy transition, but the importance of raising the debt ceiling is recognised by both parties.

In addition, with tax filing data still incoming, a more complete picture relating to the revenues should be reached by next week. This would give the Treasury a better indication of the X-date, giving both parties a hard deadline by which to reach a compromise.

That said, the highly politicised nature of the debt ceiling negotiations means the chances of failing to reach an agreement, resulting in a technical default, are arguably at their highest since 2011. Five-year Treasury credit default swap rates, a measure of the cost of insuring against Treasury defaults, have spiked in recent weeks in response to heightened concerns about a potential government default.

If history serves as a useful indicator of the future, then one would look to the debt ceiling crisis of 2011. That is the closest point of reference, even though it was also affected by the European sovereign debt crisis and weaker US economic growth. In similar fashion to the proposed Limit, Save, and Grow Act, the Republicans also demanded a reduction in government spending at that time.

Two days prior to the estimated date of budget exhaustion, the Republicans agreed to raise the debt ceiling in exchange for a host of spending cuts set out in the Budget Control Act of 2011. The result of the current uncertainty will most likely result in a sharp rise in financial market volatility similar to that experienced in 2011.

Although lawmakers typically wait until the last minute on the debt limit, they usually do come to a resolution. Congress has raised or suspended the debt ceiling 78 times since 1960.

While Congress is likely to do the same this time, the danger is whether they get the timing right. If they don’t, the consequences of a default would be severe: spiking bond yields, higher borrowing costs, plunging consumer confidence, and financial market turmoil and contagion.

Marcella Chow is a global market strategist at J.P. Morgan Asset Management