US Debt Ceiling Saga at the Final Stretch. What Happens Next?

Last week we wrote to you about the US debt ceiling saga and explained the ways it could impact the Indian stock market.

You can read the editorial here.

Well, a lot of water has flown under the bridge since last week. US politicians have reached a tentative deal to suspend the debt ceiling for two years.

So this should be great news. The markets should be soaring.

But that hasn't happened. Why?

Let's examine this issue further...

Has a debt ceiling deal been finalised?

As of this writing, the answer is both yes and no.

A tentative agreement has been reached by both political parties. This agreement will suspend the US debt ceiling for two years in exchange for several concessions by the US government. These include some reductions in spending, no new taxes, and a few other measures.

However, for this deal to be finalised, it must pass both houses of congress. And that's where things get messy.

The upper house, the Senate, is narrowly controlled by the Democratic party, i.e. the party of the current US president. Thus, the deal has a decent chance to pass here.

But before it gets there, it must first pass the lower house, the House of Representatives. This is narrowly controlled by the Republican party, i.e. the opposition.

Although the leader of the lower house has personally negotiated the deal with US president, some within his own party are unhappy. They say the deal doesn't do enough to limit government spending.

Thus, if sufficient number of Republicans oppose the deal, it won't pass the vote in the House of Representatives.

In that case, the agreement is dead and the US will hit the debt ceiling as anticipated on 1^st June.

So what happens then?

We wrote about this in our previous article...

• The US Treasury Department borrows money to fund its deficit by issuing bonds. When the debt ceiling is reached, it can no longer do so. Thus, the US government will have to cover its expenses with only its revenues.
  
  This is impossible as the US government will have a deficit of about US$ 900 billion (bn) this year.
  
  Thus the debt ceiling can create a situation where the government is unable to pay its bills, potentially leading to a government shutdown or default on debt repayments, or both.
  
  US Treasury Secretary, Janet Yellen, has warned that the US could default on its obligations in the first week of June, 2023. This is because at the current rate of spending, the US government will run out of money by around 1st June.
  
  To avoid such a scenario, the politicians in the US Congress typically takes action to raise or suspend the debt ceiling when it nears or reaches the limit. This allows the government to continue borrowing and functioning.
  
  Raising the debt ceiling does not authorise new spending but rather enables the government to meet its existing financial obligations.

So if there is no deal over the next few days, the US government won't be able to meet its existing financial obligations. These include paying salaries and providing basic government services. It could also mean a temporary pause in welfare payments.

This could trigger a recession.

In a worst case scenario, the US government could shut down as it happened back in 2011. In this scenario, only essential services and the military will continue to function.

But if the shutdown lasts for more than a few days, the US government could run out of money. This is what financial markets fear because in this scenario, the US could default on debt repayments.

Of course, there is a long way to go before we get to that shocking destination. It will probably not happen. The chances are high that even if the current agreement does not pass congress, a new agreement will be reached.

This is because no politician would want to be held responsible for a default. After all, this is exactly what happened the last time back in 2011.

Here's what we wrote about it...

• The first thing to understand is that the debt ceiling has always been raised whenever it was reached even during periods of intense political divide.
  
  This is because no politician wants to be blamed for the fallout of a prolonged period of government shutdown or a default. A compromise has been reached, always.
  
  Thus, if a compromise isn't reached this time, no one is sure what will happen. The only thing that we can say for sure is there will be significant damage to the US economy, and by extension, the world economy.
  
  A debt default by the US government would shock the global financial markets to its core. You might have already read the dire predictions about a recession as well as a crash in the stock market, among other things.
  
  The concern is valid. The last time the US was at risk of a default in 2011, stock markets had crashed. But a compromise was found at the last minute.
  
  We could see something happen along similar lines this time as well.

Impact on the stock market

The likelihood of a crash goes up if the current agreement fails and the US government shuts down.

But even in this case, the markets may remain resilient if there is light at the end of the tunnel. As long as there is no possibility of a default, markets will likely hold up.

And once the deal is done, markets will probably bounce back strongly.

Now what about the worst case scenario? What if the US really defaults?

Well, in this case the markets will crash, at least in the short term. But what really matters will be the events following the default, specifically, the response of the US government.

This is something we cannot predict because the US has never defaulted on its debt. There's no saying what could happen. Markets hate uncertainty. And this is the worst kind of uncertainty.

Conclusion

We have arrived at the final stretch of this long, drawn out saga. As of this writing, 1st June is just one day away.

There's a high chance that a deal, either in its existing form or a new one, will pass congress. The market will then put this episode behind them and move on.

But things will be tense until then.

It's very difficult to be a short-term trader in such uncertain markets. But long-term investors shouldn't worry about this issue too much.

The right strategy in this market is long term investing in the most fundamentally strong stocks in India.

Happy investing.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...