The Debt Ceiling: It’s Going Up Forever

Debt ceiling dynamics are back as the X-date approaches in the United States. We break down the potential market impacts of various resolutions and what might happen to the bitcoin price as a result.

Relevant Past Articles:

• The Everything Bubble: Markets At A Crossroads

• Quantitative Easing Or Not? A Primer On The Fed’s Shiny New Tool

• The Bond Market Meltdown Continues: Where Are The Buyers For ‘Risk-Free’ Government Debt?

• Liquidity, The Central Bank Balance Sheet & Bitcoin

• A Tale of Tail Risks: The Fiat Prisoner’s Dilemma

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Debt Ceiling Resolution Approaches 

As with most years, the grandstanding and charade of approving the United States debt ceiling limit is back once again. Through its archaic mechanism and legal hoops, the U.S. has always found a way to “uphold the full faith and credit of the United States” by changing the limit for new debt issuance that’s already been previously approved by Congress. There’s always a small chance that the U.S. government doesn’t approve the debt ceiling and defaults on its debt but that path is extremely unlikely. Either way, there are concerns and ensuing market developments that are worth analyzing to see how different scenarios may play out.

Let’s start off with the worst case projections highlighting why the debt ceiling must be resolved. The White House released analyses earlier this month from the Congressional Budget Office, Department of the Treasury and the Council of Economic Advisors which highlights the economic severity of a potential U.S. protracted debt default. The key takeaways in their worst case are: 

• Immediate, sharp recession on the order of the Great Recession, GDP will fall 6.1% in Q3.

• Unemployment will increase by 5% with over 8 million job losses in Q3 alone. 

• Widening CDS spreads which will lead to increased volatility in equity and corporate bond markets and inhibiting firms’ ability to finance themselves.

There’s widespread consensus among economists that a debt default would be catastrophic for the economy and this is the exact reason why Congress always approves the limit. This is the same sentiment across investors right now with nearly 70% of them saying they think the U.S. debt ceiling will be raised by the X-date. That sentiment has severely decreased compared to nearly 80% in April. 

Source: White House 

Source: Jeroen Blockland, BoFA

Passing debt ceiling limits and then subsequently increasing them at the last minute has become a more politicized process in the last decade. Doing so leads to more even volatility in financial markets as the potential for downgrades of U.S. credit rating and large shifts in interest rates can play out. This is what happened in 2011 when the S&P downgraded U.S. sovereign debt for the first time. 

Source: Council on Foreign Relations

New debt issuance to fund and replenish the Treasury General Account can be either neutral or a net negative for overall liquidity depending on where the issuance comes from. In short, issuance can either come from bank reserves or the reverse repo account. Generally, reverse repo funds are ones that cannot take on longer-term duration risk, so it’s more likely to see new debt issuance be covered by existing bank reserves which would reduce overall liquidity. This depends on the duration of bills that the Treasury decides to issue. 

Using the framework of net liquidity — the Federal Reserve balance sheet less the Treasury General Account and funds parked in the Reverse Repo Facility at the Federal Reserve — leading the trend for risk assets, a reduction in overall liquidity is not likely a boon to bitcoin’s valuation in the short-term. That being said, there are hints of changing sentiment among investors who are looking for a safe haven in uncertain times.

Surveys suggest professional investors most favor gold in this case, with some suggesting bitcoin over other major currencies. It’s still a long shot given the projections of the worst case scenario mentioned above. Bitcoin has certainly shown more of a correlation with gold this year, more so than equities so far, but there is a reasonable bear case for its performance in a deep recession.

Source: Bloomberg

What’s the probability of a U.S. debt default and what are the possible paths forward? Let’s dig in…