The X Factor
The Congressional Budget Office projects that, if the debt limit remains unchanged, the government’s ability to borrow using extraordinary measures will be exhausted between July and September — the so-called X-date, when the potential for adverse market and economic impacts spikes sharply. Morgan Stanley analysts estimate the X-date will be early August.
There are a range of possible outcomes with increasing degrees of risk, based on the ways in which austerity and resolution come into play before or after the X-date.
The least risky scenario for the economy and markets sees a deal reached before the X-date with no austerity measures, thus avoiding a default and the kind of spending cuts that could hamper economic growth in the near term.
At the other end of the spectrum, the riskiest involves a deal after the X-date, combined with austerity measures in an effort to trim government spending. This route would cause lasting market and economic harm to U.S. growth.
The actual outcome could be anywhere along the spectrum between these two possibilities.
Despite the risk, an early compromise looks unlikely without some kind of catalyst to prod one or both sides. While the fear of a default’s political and/or economic repercussions could provide that incentive, Congress still might not be sufficiently motivated until the X-date is very near or has passed.
There are two key ways in which the standoff, and certainly a default, could hurt markets and the economy. One relates to U.S. Treasuries, the other to consumer spending.
Effects on Treasuries
First is a selloff in Treasury bills that mature around the X-date. During previous debt episodes, this was one of the most common market reactions. For now, markets are attempting to price Treasuries within a wide window between July and September, with the curve spiking most notably in August. The window for Treasuries is likely to become narrower and the sell-off more pronounced as investors shift from Treasury bills maturing in the near term, assuming the X-date passes without a resolution.
Treasury markets could also face a drop-off in demand or forced selling. While this appears unlikely for now, that could change with an extended default or downgrade. Meanwhile, intermediate and long-term yields are likely to move lower, inverting the yield curve, as tensions over the debt ceiling persist.
Something similar happened in 2011 when Congress passed the Budget Control Act — the compromise agreement to raise the debt ceiling — three days before the X-date. With economic growth already anemic, the fiscal tightening implied by the act helped drive a 1% drop in 10-year yields.
Harm to Households
Without a resolution by the X-date, the government may also have to prioritize its principal and interest payments on Treasury securities to head off a default, and delay payments to U.S. households. That could affect Social Security, military salaries, tax refunds, food stamp benefits and unemployment insurance, among other programs.
Among these, the Treasury is likely to prioritize Social Security payments. Nevertheless, the impact on household income still would be significant, with implications for consumer spending and for the economy.
Here’s why: Government social benefits to households make up roughly 17.6% of personal income. If households were to lose all benefits apart from Social Security in a given month, consumer spending could fall by 8% to 12%.
If there is no rebound in government income in the following months of that quarter, the annualized decline in income to GDP could range from 18% to 27% quarter to quarter, which would be on par with some of the largest declines in GDP on record.
Certainly, the prospect of a government default, a bond selloff, or any delay in payments in U.S. households will have far-reaching consequences. And the closer we get to the X-date, with no real resolution in sight, the more markets — and investors — will remain on edge.