President Joe Biden and House Speaker Kevin McCarthy finally reached an agreement to avert the United States’ first default on its debt — but you may want to hold your applause. There could be an even more dramatic second act to the debt ceiling drama.
It’s not a done deal
The House of Representatives is set to vote on the bill on Wednesday, less than a week before the June 5 X-date. If the House passes the bill as expected, it would then need to be passed by the Senate and sent to Biden to be signed into law.
It’s an extremely tight timeline and adds a huge amount of pressure on the leadership of both parties.
Credit rating agencies could still downgrade US debt
Even if the bill is passed in time to avoid a default, credit rating agencies could still downgrade US debt if people lost a significant amount of confidence in the country’s ability to repay its debts on time.
That’s what merited the first-ever downgrade of US debt in 2011.
Three days after lawmakers signed a deal, Standard and Poor’s downgraded US debt from its highly coveted AAA status due to a loss in confidence in the country’s ability to repay its debts from months of squabbling among lawmakers. That sent markets sharply lower.
This time around, one of the top credit rating agencies, Fitch, has already placed US debt on rating watch negative.
“The Rating Watch Negative reflects increased political partisanship that is hindering reaching a resolution to raise or suspend the debt limit despite the fast-approaching x date (when the US Treasury exhausts its cash position and capacity for extraordinary measures without incurring new debt),” the company said in a statement last week before McCarthy and Biden reached an agreement.
As of Wednesday, the other two major sovereign debt credit rating agencies, S&P and Moody’s, have not placed US debt under review.
If Fitch downgrades US debt, it could cause yields on Treasury notes to spike, underscoring the increased risks associated with holding US debt. That would increase the cost of borrowing money since banks and other lenders often base interest rates on US bond yields.
However, the opposite occurred after S&P downgraded US debt in 2011 — investors shrugged it off and bought more bonds, sending yields lower.
Bond sales could disrupt the stock market
Assuming a deal to raise the debt limit gets passed before the X-date, the Treasury Department will need to issue more bonds to replenish the cash it burned through during the period of extraordinary measures when it could not borrow more money. This period began in mid-January after the debt ceiling was initially breached.
The agency is set to auction $114 billion in short-term bonds in the coming days, according to the Treasury’s auction sale site, and is expected to pay higher yields to bidders to fulfill its demands.
This will create more competition for equity from investors, said Michael Reynolds, vice president of investment strategy at Glenmede. After weighing their options, many investors may find the returns from investing in US Treasuries better than stocks. That will temporarily suck some liquidity out of the stock market, he said.
Additionally the new issuance “will continue to tighten economic conditions and keep front-end yields elevated in the near term,” said George Catrambone, head of fixed income, Americas at DWS Group. It’s also likely that the Treasury will announce larger-scale auctions with updated maturity schedules, he added.
“All of this could increase volatility, widen spreads, but ultimately continue to provide real alternatives to equities and low bond yields that the market had grown accustomed to.”