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Navigating the US Debt Ceiling Crisis: What's Ahead for the Financial Markets?

Navigating the US Debt Ceiling Crisis: What's Ahead for the Financial Markets?

May 27, 2023

By now, I'm fairly certain most Americans are aware that the US Treasury has reached the debt limit that can be issued to pay for expenses already appropriated by Congress. This standoff between leaders in the US House of Representatives and the US Senate has been dominating mainstream media coverage, often in a polarizing and bombastic manner. Many of the research outlets we subscribe to cover this tug-of-war, and we wish to share our understanding, as well as potential market dynamics that may emerge after a debt limit increase deal is reached — an event that is likely to occur.

Libby Cantrell from PIMCO, head of policy and political research, has been consistently providing insightful commentary on this matter since its onset. Her recent statements suggest that "deal vibes are strong" on the Hill, and House members may be summoned back to Washington DC on a 24-hour notice. The signs indicate a potential deal by Friday, May 26th or perhaps Saturday, May 27th. Speaker McCarthy has pledged a 72-hour review period for all Congressional members to examine the agreement, though this could be waived if time constraints become critical. Given the looming June 1st deadline, the House and Senate could expedite the process to reach a deal timely.

So, you might be wondering, "what is holding up the deal?" Both parties seem to agree on reclaiming unspent COVID-19 funding. The main disagreement between Democrats and Republicans is over spending caps for discretionary spending, which constitutes only 25% of the government's budget. Republicans are advocating for the fiscal year 2022 spending levels, while Democrats are pushing for 2023 levels. A compromise between these positions is the most likely outcome. The remaining issues, including energy permitting and stricter work requirements for government aid, appear to have sufficient support and are unlikely to impede negotiations.

Once a deal is announced, one might think it's the "all clear" signal for stocks to continue their climb, right? Not so fast. The US Treasury's balance sheet has been depleted to 2021 levels. Upon reaching an agreement, the Treasury will have to rebuild its balance sheet, leading to further quantitative tightening. Market players typically react unfavorably when liquidity decreases. This situation, coupled with persistently high interest rates, an increasingly inverted yield curve, and sovereign debt exceeding $32 trillion, makes the outlook for the latter half of the year murky at best and stormy at worst.

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