US Debt Ceiling: Why It Still Matters Despite A Last-Minute Deal

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US Debt Ceiling: Why It Still Matters Despite A Last-Minute Deal

Inter-party conflict over raising the US debt ceiling is becoming a regular feature of US politics. Political polarization, as well as more frequent changes in the parties controlling Congress, are likely to exacerbate this trend.

While the US defaulting on its debt remains a very unlikely scenario, concessions on fiscal policy made as part of debt-ceiling deals, as well as market volatility around the so-called "x date", mean debt-ceiling negotiations are a key political event for investors to watch.

Latest debt-ceiling talks – a familiar and risky path

The likelihood of political conflict over raising the US debt ceiling this year was always high given the current structure of Congress.

The most contentious debt-ceiling negotiations typically occur when the White House and the Senate are controlled by Democrats, while the Republicans control the lower House of Representatives (as is currently the case).

This political dynamic requires an element of bipartisan compromise to reach any agreement, but typically results in Republicans seeking greater spending concessions than Democrats are willing to give, resulting in drawn-out negotiations.

What’s more, voting patterns show that political polarization has increased, making bipartisan agreement harder to achieve – posing greater debt-ceiling risks. This will hamper future negotiations.

Voting patterns show political polarization has worsened since 2011
Voting patterns show political polarization has worsened since 2011. Source: Vote view, DW-NOMINATE, abrdn, March 2023. Note: Liberal-conservative ideological score in which -0.6 is the most liberal and 0.6 is the most conservative.

Short-term, long-term implications

As with previous tough debt ceiling negotiations, a deal was only approved by Congress at the last minute on June 2nd, just days before June 5th – the point at which the government would have exhausted its cash balances and could not borrow any more money.

The last-minute nature of debt-ceiling agreements contributes to the market stress we tend to see in the run-up to a deal being reached. While this volatility tends to disappear quickly, there can be long-lasting effects from close-run debt-ceiling negotiations.

For example, the 2011 debt-ceiling crisis resulted in a downgrade to the US's credit rating. Earlier this year, the debt ceiling was cited as the factor behind ratings agency Fitch’s decision to put the US on negative watch, indicating they were considering a downgrade.

These developments can lead to volatility in the stock market, as well as an increase in the costs of insuring US government debt.

Previous debt ceiling negotiations show volatility in equity and bond markets occur even when an agreement is reached.
Previous debt ceiling negotiations show volatility in equity and bond markets occur even when an agreement is reached. Source: Haver, abrdn (May 2023).

What’s been agreed?

The deal that was struck between President Joe Biden and Republicans means cuts to government spending over the next two years, while suspending the debt-ceiling review until January 2025. Non-defense spending will be held mostly flat relative to 2023 in 2024, with budgets increasing by 1% in 2025.

Given the pace of inflation, this amounts to a modest cut to government spending, but less than the 9.2% reduction Republicans had originally sought.

Relative to planned spending increases, the agreement roughly amounts to less spending equivalent to some 0.2%-0.3% of the annual size of the economy. Republican plans would have equated to a drag of around 0.5 percentage points on economic growth in 2024, with further hits in subsequent fiscal years.

The biggest impact of the deal is likely to be that the government will be unable to introduce large spending programs to support the economy in the event the US slips into recession.

With President Biden’s hands tied by the spending caps, the US government will be left relying on existing policies to address any increase in unemployment an economic downturn may cause.

Political risks in the US persist

Even though the risks of the US defaulting on its debt have receded since the deal was passed and signed into law, there continue to be repercussions.

A small group of Republicans unhappy with the agreement have blocked all legislation from progressing in the House – resulting in political gridlock. They are seeking significantly greater spending cuts than those agreed.

This sets up the 2024 budget negotiations process as the next high-stakes moment in US politics, with potentially significant implications for businesses exposed to US government funding, as well as those receiving social security payments.

If the 2024 budget is not agreed by September 31, a government shutdown is possible. Under the terms of the debt-ceiling agreement, failure to reach an agreement on the 2024 budget will result in a blanket 1% cut to all budgets, which would further reduce the government’s ability to introduce new spending measures ahead of the 2024 election.

Investors must be mindful of US politics

The recent debt ceiling clash is only one example of the ways in which politics in the US can have market implications.

With the government budget negotiation process yet to begin and the 2024 US presidential election beginning to appear over the horizon, policy volatility and uncertainty over the direction of travel may weigh on markets.

This trend shows little signs of abating any time soon, making domestic politics in the US a key area to watch going forward.



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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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