As the US Congress makes progress on infrastructure legislation, it is the US debt ceiling that is of concern to investors.
The debt ceiling represents the limit of how much debt the United States can issue to pay for previous and future expenses. Having been suspended from August 2019 until July 31, 2021, it will have to be lifted in October or November, when the US Treasury is likely to run out of “extraordinary measures” to finance government activities. While it is widely believed that, of course, Congress will raise the debt ceiling – failing to do so would be almost unthinkable and would harm Democrats politically – the strategy to implement it remains obscure at best, which could agitate financial markets and could increase financial possibility of a political error.
The market implications of a binding debt ceiling
According to Libby Cantrill, Head of Public Policy di PIMCO, markets have so far appeared optimistic about the prospects of avoiding a disruptive debt ceiling event this fall. However, a lesson from previous episodes is that markets cannot be relied upon as an early warning indicator.
The market implications of a binding debt ceiling are complicated, the expert says, and as the Treasury is expected to reduce cash balances as the ceiling approaches, it is likely to tap into bonds. This drop in supply could cause government bond yields to drop – a counterintuitive move. A flight to government bond safety resulting from broader market risk aversion could push yields further down.
“In our view it would be a mistake for investors to assume that there would be no major market implications if Congress fails to address the debt ceiling issue this time around. As we observed in both September 2019 and March 2020, the liquidity of the finance market is critical to its functioning, and the perceived security of US public debt is the foundation. Therefore, it is important not to misinterpret the calm and patience exemplified in the current market conditions as a state of diminishing risk. Instead, investors should keep their eyes peeled for pockets of volatility as we head towards the end of 2021. ” Cantrill.