With negotiations underway, a US default remains a low but distinct possibility. When might the default “x-date” fall – and how will markets respond?
George Brown, Economist, Schroders
The US risks default in a matter of weeks unless Congress can reach a deal to raise the country’s borrowing limit.
While negotiations are underway, if the “x-date” (see below) passes without the debt ceiling being raised, coupon payments and redemptions of Treasury securities will stop.
While technical lapses have occurred – such as the 1979 check-processing glitch that delayed some redemption requests – a true default would be an unprecedented event with far-reaching ramifications.
Why the precise x-date deadline is uncertain
The x-date would mark the point at which the Treasury runs out of funds. After disappointing tax receipts for 2022, much now hinges on how revenue shapes up through May. If this can sustain the government into mid-June, when quarterly tax payments are due, the Treasury is likely to be able to make it through much of July and perhaps even to August.
What needs to happen to avoid default?
After much internal wrangling, Republicans have unified behind one position and begun negotiations with the White House. Even if the two sides eventually strike a deal, as we expect, it would still need to clear Congress. Beyond the limited legislative timeframe, the main obstacle will be ultraconservative Republicans who could obstruct it by unseating the speaker to prevent bills from being brought to the floor.
However, some centrist Democrats are reported to have privately assured the speaker that they would come to his aid under such circumstances. President Joe Biden has also openly explored using section four of the 14th amendment, which states that the validity of US public debt “shall not be questioned”. But this unprecedented unilateral action could end up being struck down by the Supreme Court.
So although a default is unlikely, it should not be ruled out. As always, context is important. Investors would probably perceive any default to be a consequence of the fractious political environment rather than a fundamental inability of the US to meet its debt obligations. That being said, we still expect risk-off sentiment to grip markets over the coming weeks, which could be magnified by persistent concerns about the soundness of the banking system.
Investors’ portfolio response
Our message for investors therefore remains the same: hope for success, but plan for failure. Where possible, portfolios ought to be liquid and diversified to ensure capital can be redeployed quickly given the volatility seen during prior episodes of debt ceiling brinkmanship. However, it would be a mistake to assume that assets will perform as they did before. For instance, the rally in Treasuries during the 2011 standoff coincided with concerns about the eurozone debt crisis.
Outlook for Treasuries
While it is conceivable that Treasuries could perform well over the coming weeks, this is by no means guaranteed. Our strongest conviction is to have an overweight allocation to gold, even in spite of the recent rally, as well as towards AAA-rated sovereign issuance such as German Bunds. Alongside this, we would also expect safe haven currencies such as the Japanese yen and the Swiss franc to perform well against the US dollar.
Outlook for equities
On the other hand, equities will probably find themselves under the most pressure. But there is likely to be a wide divergence beyond the headline indices. Companies that have a heavy reliance towards US government spending or subsidies are likely to come under the most pressure. Whereas value stocks could hold up better, as should defensive and non-cyclical sectors such as pharmaceuticals
Finally, for those willing to bet that Congress will manage to raise the debt ceiling in time, some investors may look to arbitrage the yield gap between T-Bills maturing before and after early June. Key to this will be timing, with the opportune moment being when concerns over the debt ceiling peak.
We are not yet at that stage, but it ought not to be far away.