22 May 2023
At some point in the 2010s, it became unfashionable to worry about the long term fiscal outlook. Inflation was extraordinarily low and interest rates were set low in response. Post-2008 worries about inflation from QE proved misplaced. Reinhardt and Rogoff’s link between high debt and low growth was flattered by an excel error. High inequality, the need for massive green investment, and unpopular austerity measures led prominent analysts to adopt Keynes’ mantra, “anything we can do we can afford.”
In this context, the 2023 debt ceiling fight feels like an anachronism—Republicans and Democrats fighting to invalidate spending that has already been approved, even after both parties have spent like drunken sailors, to use John McCain’s phrase. And the fact that this feels so anachronistic is why we think the standoff will probably be resolved. Both sides are in a very different place from where they were in the early 2010s. Nevertheless, this is unlikely to be the last fiscal bunfight in a new era of higher rates and inflation.
Broadly, there are four scenarios for how this debt ceiling skirmish could play out: a) most likely, a negotiated deal, probably involving some spending cuts and regulatory changes, b) a debt ceiling increase without Congressional agreement (via executive action or an unusual manoeuvre), which is less likely given the legal challenges that may result, c) a no deal scenario with the prioritisation of interest payments and d), with a vanishingly small probability, no deal with full default.
We think a negotiated deal is most likely because first, unlike 2011 and 2013, deficit concerns are not in the foreground today. Second, Republicans are less united than in the early 2010s, when their majority in the House was also much bigger. The composition of the $3.2tn of the discretionary spending cuts in the Limit, Save, Grow Act remain undisclosed because Republicans would rather not defend cuts to popular programs. Third, the Biden administration may in fact want, sotto voce, some fiscal restraint given the current macroeconomic juncture. In 2011, unemployment was high, and inflation was low; today it is the opposite. Finally, the Senate has been quite effective in getting bills passed in recent years, and there are some solid working relationships to act against the impasse.
The market implications of a resolution would be a repricing of the US macro outlook as a tail-risk to growth is avoided; the US rates curve will move modestly up in response. It will also result in the reversion of specific market anomalies, e.g. the T-bill curve will normalise. Finally, the liquidity outlook will paradoxically deteriorate as the US Treasury begins to rebuild its cash balance and liquidity is drained from the US economy, which is likely to be negative for US equities even if there will be some immediate relief in markets.
Looking further ahead there are some serious structural headwinds around the fiscal situation for markets to understand.
For one, US deficits are likely to be much higher. In its May update, the Congressional Budget Office projected that America’s deficit would average 6.1% of GDP over the next decade, well above the 3.2% average from 1980-2019. High deficits are not a problem when nominal interest rates are lower than nominal growth rates, as they were in the 2010s and in the Covid recovery period. That is because the power of compound interest is offset by the power of compound growth, so debt ratios do not snowball. But if nominal growth were to fall, for instance through normalising inflation or a recession, then debt levels could rise sharply. By 2033, the CBO projects federal debt to surge to 119% of GDP, surpassing its average over the past 50 years by about two and a half times.
It would be one story if debts were higher because of ambitious government programs. But the bulk of the deficit increase is just higher interest costs, and three-quarters of the growth in interest costs can be accounted for by increases in the average interest rate on federal debt. Net interest outlays will go from 1.9% of GDP in 2022 to 3.7% by 2033.
For context, the US defence budget is supposed to shrink from 3.0% to 2.8% of GDP in this period, apparently in the face of a geopolitical challenge from China. Moreover, these forecasts from the CBO assume that the average interest cost on US debt rises quite modestly, from 2.7% to 3.2% by 2033.
It is easy to imagine worse scenarios.