Article written by Prieur du Plessis, editor of the Investment Postcards from Cape Town blog.
This post is a guest contribution by David Greenlaw and Ted Wieseman ofMorgan Stanley.
A statutory limit on the amount of federal government debt outstanding has been in place since 1917, when Congress enacted the Second Liberty Bond Act. The current limit is $14.294 trillion. Since 1940, the debt ceiling has been increased on 80 separate occasions.
The ceiling applies to almost all federal debt, including: 1) marketable issuance, 2) non-marketable securities (such as savings bonds and special state & local government securities (or SLGS), and 3) debt that the US government owes to itself (such as trust fund obligations for social security, Medicare, civil service retirement, etc.). Thus, the public auctions held by the Treasury on a regular basis are not the sole determinant of growth in the debt subject to limit. Indeed, intragovernmental obligations currently account for nearly one-third of the overall debt subject to limit, and manipulation of these accounts can create additional room to borrow from the market.
In early January, we published a note on the debt ceiling (see The Looming Debt Ceiling Showdown, Greenlaw and Wieseman, January 6, 2011). Since that point, events have played out pretty much according to script. Recently, Treasury Secretary Geithner sent a letter to Congress indicating that the government would hit the current debt ceiling around May 16 (the day the May refunding settles) and would exhaust the usual measures that have been employed in the past to maneuver around the debt ceiling by August 2. The timetable laid out by Geithner is very close to the original estimates contained in our January note. However, we now believe that the Treasury may have a bit more room and could possibly make it to mid-August. The slightly more optimistic borrowing assessment largely reflects the upside surprise seen in the April 15 tax payments by individuals. Based on nearly complete data, we estimate that payments during the 2011 filing season surged about 30% from a year ago. We had been assuming a more modest increase.
We estimate that the so-called ‘extraordinary actions’ that Geithner is authorized to deploy amount to about $300 billion and provide a few extra months of borrowing capacity beyond the mid-May deadline. Most of these actions involve bookkeeping entries with no real economic or market impact. The one notable exception is the suspension of SLGS issuance. SLGS are special non-marketable state & local government securities that are issued by Treasury as part of a municipal refunding deal. SLGS issuance was suspended in early May, so any issuer doing a refunding will be forced to defease the outstanding securities by purchasing Treasuries in the secondary market. Recently, gross SLGS issuance has been running at a pace of about $6 billion per month, but it is highly dependent on refunding opportunities in the muni market and thus the level of interest rates.
Some have argued that the Treasury can manage its cash in a way that avoids default. For example, see the Wall Street Journal op-ed’s by Senator Pat Toomey and former Treasury official Emil Henry. However, the approach that they are advocating does not seem at all workable to us. The Treasury’s cash flows are too lumpy to simply prioritize one form of spending over another. For example, we would expect a significant political outburst if the Treasury withheld monthly social security checks at the beginning of the month (even though there was sufficient cash on hand to make the payments) just in case they needed this cash to make debt service payments at mid-month. Such a scenario is highly impractical – and probably not even legal. Norm Carleton, a former long-time senior Treasury official, has offered a similar criticism of the Toomey/Henry strategy.
Asset sales of gold, student loans and/or MBS by the Treasury represent yet another suggested means of avoiding default. The Treasury has about $125 billion of MBS – which it is in the process of liquidating at a pace of about $10 billion per month (continued sales at this pace are already factored into our borrowing estimates). And, at the current market value of around $1,500/ounce, the US government’s holdings of gold are worth nearly $400 billion. The Treasury also has about $400 billion of student loans currently on its books. However, the legal authority for the Treasury Secretary to liquidate the US gold holdings and/or to securitize and sell off its portfolio of student loans is murky at best. Moreover, senior Treasury officials have thrown cold water on the notion that asset sales might be part of the Treasury’s strategy. Mary Miller, head of Treasury debt management, recently told Bloomberg News: “A fire sale of financial assets would be damaging to the economy, taxpayers, and financial markets. It would harm the interests of taxpayers, and would undermine confidence in the United States.”
So, how might all this play out? From a practical standpoint, there is virtually no chance of a default. The risks surrounding the debt ceiling showdown are more about potential auction disruptions and investor uncertainty, because this is an issue involving willingness rather than ability to pay. If Congress doesn’t act to raise the limit on a timely basis, the Treasury could always roll out new – and therefore untested – measures that will extend the authority to issue additional debt. For example, during the 1995-96 experience, Treasury Secretary Rubin declared a 1-year debt issuance suspension period (DISP) in order to disinvest trust fund balances and free up additional marketable borrowing authority. This action was subsequently declared appropriate by government lawyers and the General Accounting Office. Thus, what’s to stop a Treasury Secretary from declaring a 2-year or longer DISP and disinvest enough to continue to borrow? At some point, such action might be deemed illegal, but that is likely to come well after the fact. We think this is no way to operate a highly advanced economy such as the US. And, the risk of investor confusion obviously begins to rise as the US political system appears to become more and more dysfunctional. It really boils down to a high-stakes game of chicken.
Path to compromise is foggy. Clearly, this is going to be a tough vote for many members of Congress. Some political insiders are comparing it to the 2008 TARP vote, which seemed to be an important catalyst for the defeat of many members in the House and at least two Senators (Bennett of Utah and Hutchison of Texas). While all the experts agree that a debt ceiling hike will eventually be enacted, the path to a compromise is very foggy at this point. A couple of weeks ago, it appeared that some sort of automatic trigger for budget cuts (possibly a new version of Gramm-Rudman or PAYGO) might be part of a compromise agreement. However, Republican leaders now appear to have shifted gears and are demanding upfront spending cuts that match the requested increase in the debt ceiling. Meanwhile, Democrats still hope to get a clean bill, and the president has reportedly ruled out any form of spending caps.
Basically, negotiations appear to be back to square one. At the end of the day, there will probably be some type of gimmick introduced that yields a compromise agreement. For example, a debt ceiling hike was approved in 2009 only after there was an agreement that a blue-ribbon commission would be established to study the US budgetary situation and make recommendations. The Simpson-Bowles commission did exactly that and presented some thoughtful recommendations aimed at addressing the long-run budgetary imbalance in the US. But these recommendations were summarily dismissed by political leaders on both sides of the aisle who do not want to face the tough choices that are involved in addressing our long-run structural budget deficit.
So, we believe it is appropriate to remain skeptical that there will be any meaningful fiscal policy changes resulting from a deal to hike the debt ceiling. Instead, it’s more likely that we will get smoke and mirrors along the lines of the recent resolution to the government shutdown debate. In that instance, Congress delivered a package that claimed $40 billion of budget cuts. However, analysis by the CBO subsequently revealed that the actual savings in F2011 were less than $1 billion.
We continue to believe that meaningful deficit reduction won’t occur until the financial markets force the issue. We illustrate in the full report some basic budget math that highlights the problem. On the spending side, healthcare costs have been exploding and are on a path to grow even more rapidly in coming decades. Indeed, under current policies, the CBO estimates that federal government spending, excluding interest on the debt, will amount to nearly 30% of GDP by the middle of this century. While the numbers appear to provide a relatively straightforward indication of where cuts might be needed, the situation becomes much more complicated when political factors enter into the equation. For example, a recent ABC News/Washington Post poll found that 78% of respondents oppose any cuts whatsoever in Medicare. Other polls on this topic have reported similar results. And, after apparently getting an earful from their constituents while they were home for Easter recess, Republicans already appear to be backing away from the dramatic cuts in healthcare spending contained in Budget Committee Chairman Paul Ryan’s blueprint.
Meanwhile, on the tax side of the ledger, revenues have tended to fluctuate around 18% to 20% of GDP over the past 50 years or so. Of course, revenues are now well below historical norms because of the recession and prior tax cuts. But, even if ALL of the 2001 and 2003 Bush tax cuts expire at the end of 2012 (as currently scheduled), the payroll tax cut expires at the end of 2011 (as currently scheduled) and the economy achieves full employment, the CBO estimates that revenues will only be around 21% of GDP by 2020. So, we are facing a long-term structural deficit of 10% of GDP or more (after factoring in interest costs). This is the basic arithmetic that points to an unsustainable situation over the long run.
How should investors play the looming debt ceiling showdown? In general, this is a very tough issue for the market to handicap. Here’s why: Under one plausible scenario, there is panicked selling of Treasuries because of general investor confusion. For example, at one point during the 1995-96 debt ceiling episode, House Speaker Newt Gingrich appeared on one of the Sunday talk shows and actually stated his willingness to force the government into default (see The Debt Ceiling and Executive Latitude, Bradford and Constadine, Harvard Law School Briefing Paper #11, January 2009). Several months later, he reiterated this position, and press reports at the time suggested that the Speaker’s remarks were at least partially responsible for a significant drop in the value of the dollar during one trading session. Although a number of key Congressional leaders have indicated that they will “act like adults” this time round, there is always the possibility that misguided statements by political leaders could prove to be a source of investor concern. Foreign investors might seem to be particular susceptible to confusing statements coming out of Washington. That’s important because foreign investors own more than 50% of the privately held Treasury coupon debt outstanding.
Of course, investors have been through debt ceiling showdowns before and should realize that doomsday fears are dramatically overblown. Moreover, we’ve all just been through a false alarm on a similar fiscal deadlock (i.e., the government shutdown).
Under an alternative scenario, investors realize that there is essentially zero risk of default. Also, there may be hope that a debt ceiling compromise could include some meaningful deficit reduction. Most importantly, we may be headed for a situation in which Congress grants a series of short-term extensions to the debt ceiling, leading the Treasury to postpone coupon auctions and replace the issuance with cash management bills. Indeed, Treasury officials appear to be preparing for just such a scenario. Mary Miller, the current head of debt management at the Treasury Department, delivered a carefully worded statement along these lines at the May refunding announcement. So, we could see a significant amount of duration being taken out of the market for a period of time – which would amount to a quasi-QE3.
Also, as mentioned previously, the suspension of SLGS issuance would imply the potential for some secondary market demand for long-duration Treasuries from municipal issuers. Obviously, this type of supply/demand shift could trigger a rally in long-dated fixed income. Moreover, risky assets would benefit under the Fed’s portfolio balance model of QE (i.e., taking duration out of the Treasury market pushes investors into riskier asset classes).
We’ve outlined two dramatically different market scenarios – one in which the debt ceiling debate triggers fear and uncertainty, leading to higher yields, and the other in which the supply/demand fundamentals help to drive rates lower. This is one of those issues in which anyone who has a basic understanding of the key issues can make their own assessment on the basis of how they think investors will behave.
Source: David Greenlaw and Ted Wieseman, Morgan Stanley, May 17, 2011.
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Debt ceiling showdown: an update was first posted on May 18, 2011 at 7:50 am.
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