Show Transcript
President Joe Biden and Republican leader Kevin McCarthy are vowing not to let the U.S. default as debt ceiling negotiations continue and the deadline quickly approaches. Christian Medeiros, Portfolio Manager with TD Asset Management, looks at four possible outcomes.
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- While there are some signs of progress in the US debt ceiling talks, American lawmakers still haven't reached a deal. Joining us now with four potential scenarios and where things could go from here, Christian Medeiros, portfolio manager with TD Asset Management. Christian, great to have you back on the show.
- Thank you.
- So as we talk, and we talk, and we talk and get closer to an American long weekend, you've got to start sort of mapping out what could happen here. You have four scenarios. Walk us through this. What's number one?
- Yeah, so number one is actually getting a deal and passing it through the House. And this is really what's going to have to happen at the end of the day, the most likely outcome in order for us to get through this. So we're one week away. Next Thursday is the X date on June 1.
What we would expect, if this scenario were to play out, is an announcement of some sort of deal by sometime on the weekend, which would give legislators enough time to go over the bill, pass it through the House and Senate, have the president's signature, and get it all done before the X date. So that's the first scenario and the best case scenario.
- Best case, obviously the cleanest scenario, too, in terms of all this. So short of that, let's go to number two.
- Number two is delay. So if we can't get a deal done, we can't come to an agreement, let's buy ourselves more time. Two ways to delay things. The first, and the best outcome of the delays, would be to just pass a short-term extension.
Let's kick it down the road, maybe a few weeks. Maybe we could get to the budget negotiations in September. Buy us a few more months or a few more weeks to discuss the debt ceiling. The second issue-- the second way of delaying it, this is much more problematic, but it's technically possible-- is the Treasury could decide if we go through the X day and don't have any deal, we haven't raised the debt limit, hey, let's just prioritize payments only on principal and interest.
And so that way we avoid a default for the US government. The problem with that, though, is that there's a lot of other expenditures the Treasury has to make. And without the ability to raise new debt, they won't be able to cover a lot of those expenditures.
So if that persists, that payment prioritization persists for weeks, days, maybe longer, that's a very material hit to GDP as you miss out on the government expenditure. And the second thing is you wouldn't be able to avoid a downgrade in US government debt because I think rating agencies would get quite skittish in that scenario.
- I think Fitch just last evening sort of put them on notice saying, we're watching this, and you know, your rating-- its triple-A rating right now for the United States. So that's at stake. OK, so just get a deal, get it all behind us, move on. Delay it. Number three, I think as you put it, some more fanciful resolutions. Some-- I wouldn't say wild ideas, but some very interesting ideas have been thrown out there in the past couple of weeks.
- Yeah, Jerome Powell called these in some recent meetings and testimonies, he called it the rabbit and the hat. So, these are more out-there scenarios that people are discussing. One would be a trillion dollar coin. So, technically the Treasury can mint a trillion dollar denominated coin, deposit that with the Fed into their Treasury General account and then spend that, and not have to worry about raising new debt.
Both parties don't think that this is a good option for many reasons. So it's quite unlikely that we mint a trillion dollar coin. The second one that's talked about a little bit more is called the 14th Amendment. Technically in the US Constitution, there's a 14th Amendment that says the US debt needs to be honored effectively.
It's very debatable whether the Supreme Court and legal challenges would stand up if the president were to say, I invoke the 14th Amendment. Treasury continues to issue debt. Let's avoid the debt ceiling. It's unconstitutional.
What would happen in that scenario is that any debt issued after that 14th Amendment would be a second tier of Treasury, because people would be unsure if the Supreme Court would say, hey, it's valid, or hey, this isn't valid. So that's a very risky scenario, and we don't think that would happen unless we're in the absolute worst case scenario.
- OK, that sort of leads us, I think, into number four, a worst case scenario here.
- Yeah, the worst case scenario would be an absolute default. Again, we have two parties playing a game of chicken. We're getting closer and closer to the cliff. But as I mentioned, there's a number of parachutes that would prevent us from getting to a default. Could delay it, could use debt prioritization, just paying those interest payments.
We could use the 14th Amendment, maybe some other whacky scenarios. But if all those were to fail, then there would be a default, because we would be missing interest payments on those debt after the X date. So, that'd be the worst case scenario. That'd be a severe market event. That would really challenge--
- Do we even understand the implications of that market event? I've talked to people who've basically said, because we'd be in this sort of uncharted territory, we know it would be serious. But we can't say this, this, and this will happen, because we simply don't know.
- We don't. So one is an operational consideration, it's a bit like a Y2K event. We've never dealt with US treasuries defaulting before. Our brokers, our platforms, everyone ready to deal with defaulted Treasury Securities, are the technology systems on the back-end of the financial market's prepared to deal with that? Would it still be allowable as collateral? If not, then we could have pretty severe liquidation events or concerns in a default scenario.
The other aspect is the US government debt is the risk-free asset for the entire world. It's a very important asset class. And so if that were to be called into question, that would raise a whole bunch of issues for all asset classes. So, I think that would be a very negative market event, but it's one that there's a lot of mechanisms we have in place to hopefully avoid.
- Now, investors could be forgiven given the track record of the past decade or more of that when you run into some kind of trouble, the central bank, the Fed, just rides to the rescue. And if you do end up in a default scenario, is there anything the Fed can do?
- So we have some indications of what they might do, because back in 2011 when we had another very contentious debt ceiling conflict, we had a meeting of the Fed soon after that deal was enacted. And they discussed, hey, what would we have done if things got really bad? And so what they would do is mostly provide liquidity to the market through a repo reverse repo facilities.
Perhaps support money market funds. Then also there was some discussion of maybe swapping defaulted securities as well. So there's things that they could do to provide liquidity to the market, but they were very careful in those minutes to make sure they don't void the Fed's independence, right? They don't want to be seen as financing the government or getting in the way of fiscal policy.
So they would provide liquidity to make sure markets still function as smoothly as they possibly can, but the Fed cannot save this scenario. At the end of the day, legislators need to pass a debt ceiling raise in order to solve this issue.
[MUSIC PLAYING]
- Thank you.
- So as we talk, and we talk, and we talk and get closer to an American long weekend, you've got to start sort of mapping out what could happen here. You have four scenarios. Walk us through this. What's number one?
- Yeah, so number one is actually getting a deal and passing it through the House. And this is really what's going to have to happen at the end of the day, the most likely outcome in order for us to get through this. So we're one week away. Next Thursday is the X date on June 1.
What we would expect, if this scenario were to play out, is an announcement of some sort of deal by sometime on the weekend, which would give legislators enough time to go over the bill, pass it through the House and Senate, have the president's signature, and get it all done before the X date. So that's the first scenario and the best case scenario.
- Best case, obviously the cleanest scenario, too, in terms of all this. So short of that, let's go to number two.
- Number two is delay. So if we can't get a deal done, we can't come to an agreement, let's buy ourselves more time. Two ways to delay things. The first, and the best outcome of the delays, would be to just pass a short-term extension.
Let's kick it down the road, maybe a few weeks. Maybe we could get to the budget negotiations in September. Buy us a few more months or a few more weeks to discuss the debt ceiling. The second issue-- the second way of delaying it, this is much more problematic, but it's technically possible-- is the Treasury could decide if we go through the X day and don't have any deal, we haven't raised the debt limit, hey, let's just prioritize payments only on principal and interest.
And so that way we avoid a default for the US government. The problem with that, though, is that there's a lot of other expenditures the Treasury has to make. And without the ability to raise new debt, they won't be able to cover a lot of those expenditures.
So if that persists, that payment prioritization persists for weeks, days, maybe longer, that's a very material hit to GDP as you miss out on the government expenditure. And the second thing is you wouldn't be able to avoid a downgrade in US government debt because I think rating agencies would get quite skittish in that scenario.
- I think Fitch just last evening sort of put them on notice saying, we're watching this, and you know, your rating-- its triple-A rating right now for the United States. So that's at stake. OK, so just get a deal, get it all behind us, move on. Delay it. Number three, I think as you put it, some more fanciful resolutions. Some-- I wouldn't say wild ideas, but some very interesting ideas have been thrown out there in the past couple of weeks.
- Yeah, Jerome Powell called these in some recent meetings and testimonies, he called it the rabbit and the hat. So, these are more out-there scenarios that people are discussing. One would be a trillion dollar coin. So, technically the Treasury can mint a trillion dollar denominated coin, deposit that with the Fed into their Treasury General account and then spend that, and not have to worry about raising new debt.
Both parties don't think that this is a good option for many reasons. So it's quite unlikely that we mint a trillion dollar coin. The second one that's talked about a little bit more is called the 14th Amendment. Technically in the US Constitution, there's a 14th Amendment that says the US debt needs to be honored effectively.
It's very debatable whether the Supreme Court and legal challenges would stand up if the president were to say, I invoke the 14th Amendment. Treasury continues to issue debt. Let's avoid the debt ceiling. It's unconstitutional.
What would happen in that scenario is that any debt issued after that 14th Amendment would be a second tier of Treasury, because people would be unsure if the Supreme Court would say, hey, it's valid, or hey, this isn't valid. So that's a very risky scenario, and we don't think that would happen unless we're in the absolute worst case scenario.
- OK, that sort of leads us, I think, into number four, a worst case scenario here.
- Yeah, the worst case scenario would be an absolute default. Again, we have two parties playing a game of chicken. We're getting closer and closer to the cliff. But as I mentioned, there's a number of parachutes that would prevent us from getting to a default. Could delay it, could use debt prioritization, just paying those interest payments.
We could use the 14th Amendment, maybe some other whacky scenarios. But if all those were to fail, then there would be a default, because we would be missing interest payments on those debt after the X date. So, that'd be the worst case scenario. That'd be a severe market event. That would really challenge--
- Do we even understand the implications of that market event? I've talked to people who've basically said, because we'd be in this sort of uncharted territory, we know it would be serious. But we can't say this, this, and this will happen, because we simply don't know.
- We don't. So one is an operational consideration, it's a bit like a Y2K event. We've never dealt with US treasuries defaulting before. Our brokers, our platforms, everyone ready to deal with defaulted Treasury Securities, are the technology systems on the back-end of the financial market's prepared to deal with that? Would it still be allowable as collateral? If not, then we could have pretty severe liquidation events or concerns in a default scenario.
The other aspect is the US government debt is the risk-free asset for the entire world. It's a very important asset class. And so if that were to be called into question, that would raise a whole bunch of issues for all asset classes. So, I think that would be a very negative market event, but it's one that there's a lot of mechanisms we have in place to hopefully avoid.
- Now, investors could be forgiven given the track record of the past decade or more of that when you run into some kind of trouble, the central bank, the Fed, just rides to the rescue. And if you do end up in a default scenario, is there anything the Fed can do?
- So we have some indications of what they might do, because back in 2011 when we had another very contentious debt ceiling conflict, we had a meeting of the Fed soon after that deal was enacted. And they discussed, hey, what would we have done if things got really bad? And so what they would do is mostly provide liquidity to the market through a repo reverse repo facilities.
Perhaps support money market funds. Then also there was some discussion of maybe swapping defaulted securities as well. So there's things that they could do to provide liquidity to the market, but they were very careful in those minutes to make sure they don't void the Fed's independence, right? They don't want to be seen as financing the government or getting in the way of fiscal policy.
So they would provide liquidity to make sure markets still function as smoothly as they possibly can, but the Fed cannot save this scenario. At the end of the day, legislators need to pass a debt ceiling raise in order to solve this issue.
[MUSIC PLAYING]
