Debt Ceiling VS Budget

At the end of September, the White House faces two major clashes with Republicans in Congress in the coming month.  First, Congress needs to approve a new budget acceptable to the White House by the end of the month or face a government shutdown. Then lawmakers will debate raising the debt ceiling before mid-October to fund public spending and avoid a possible sovereign default. So far, the US House Republicans are demanding the healthcare package known as ‘Obamacare’ to be delayed or de-funded altogether in any budget or debt ceiling agreement. Obamacare is one of President Obama’s most notable achievements, so it is unlikely he will agree to any measures that deter its implementation. Both sides are dug in, making it difficult to anticipate agreement on both the budget and debt ceiling.

Debt Ceiling Rises?

Another debt ceiling confrontation could introduce considerable uncertainty into financial markets. Most market participants have focused primarily on the next Federal Reserve chairman and US monetary policy in the absence of meaningful fiscal policy. However, if budget talks push into October and become entangled with the debt ceiling with little sign of resolution, Congressional wrangling may once again dominate market sentiment. The outcome of such a standoff is likely to set the tone for US markets in the near future, with potential scenarios seen as follows:

  1. Delay in raising the debt ceiling:  As Republicans insist on tying the new budget to defunding or delaying implementation of Obamacare, which is a demand that Democrats are unwilling to accept. Faced with an impasse over the fiscal and health policy between Democrats and Republicans, and neither side is willing to budge from their position, Congressional Republicans could refuse to vote to raise the debt ceiling and potentially push the US government into default.

An unprecedented US default would have far ranging and potentially dramatic results. It could spark another financial crisis and throw the US economy back into recession. Markets could collapse not just in the US, but also globally. In any case, the US bond market would likely see soaring interest rates, which would increase both future borrowing costs of the federal government and capital costs for US businesses. Rating agencies may further downgrade the US government credit rating as S&P did in 2011. The stock market in the US could suffer a major correction on a scale not seen since 2008. A loss of confidence in the debt market could prompt foreign creditors to have a run on the dollar, leading to dollar depreciation while the price of gold increases in a ‘flight to safety’.

  1. Temporary short-term solution: It is not in the interest of either Republicans or Democrats for the US to default on any of its debt, making at least some type of stop-gap compromise likely. Even though Republicans have the House majority ready to vote against raising the debt ceiling, the strategy could ultimately politically hurt them. Last minute negotiations and short-term compromise seem likely, such as those seen in previous debt ceiling and budgetary standoffs.

The market currently seems to be pricing in an expected eleventh hour compromise that would effectively maintain the status quo. As a result, such an agreement seems unlikely to cause major moves in the US bond and stock markets. Equity markets will likely be sensitive to the events leading up to the agreement and the details of the compromise, but longer-term bond yields should remain stable. The both the dollar and gold will largely remain sensitive to comments and actions from the Federal Reserve as opposed to the ongoing deadlock at the fiscal policy level.

  1. Long-term bipartisan agreement: With a US default in the interest of neither party the debt ceiling will likely be increased, but few expect a more substantial long-term bipartisan agreement. If Republicans can capitalize on Obamacare’s limited popularity among the general public and Obama finds an acceptable ground on which to compromise, there may be a chance for a more lasting debt ceiling deal. A relatively longer-term bipartisan agreement which begins to tackle the country’s longer-term fiscal problems, could cause financial market participants to seriously re-align their expectations regarding future US fiscal policy.

A long-term agreement would not only include a higher debt ceiling in the short term, it could also reduce the perceived uncertainty and risk around US government fiscal policy. This would imply a more expansionary fiscal policy than what is currently expected, leading revised market expectations to drive up expected output and interest rates faster than anticipated. A higher rate of return would likely attract foreign capital, leading to dollar appreciation. US equity markets would likely see the removal of the ‘deadlock’ as a short term to medium term positive even with higher interest rates. Such an increased rotation in US financial assets in the short term could put significant downward pressure on the price of alternative safe havens such as gold.


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HedgeSPA Research Team – 25 September, 2013