Michael Zezas: Congress Contends with the Debt Ceiling

Congress is finally set to begin debt ceiling negotiations. What are some possible outcomes and how might the negotiations affect economic growth?

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Welcome to Thoughts on the Market. I'm Michael Zezas, Global Head of Fixed Income and Thematic Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the debt ceiling and its impact on markets. It's Wednesday, May 3rd at 9 a.m. in New York.

Earlier this week, the Treasury Department informed Congress that at the start of June, it could run out of money to pay government obligations as they come due. This X-date appears much earlier than most forecasters expected, catching markets by surprise. Some investors even expressed to us disbelief, pushing the idea that the real X-date would be later, and Treasury is just trying to stir negotiations in Congress to raise the debt ceiling. Here's our take.

The X-date is likely a moving target due the complex interplay of the timing of incoming tax receipts, government outlays and maturing debt securities. So, while it's possible the date ends up being sometime later this summer, the government might not be able to forecast that with a high degree of certainty. In that case, negotiations have to start now to avoid a situation where the X-date sneaks up on Congress, leaving little time to deliberate and risking default.

And that seems to have prompted negotiations, with a May 9th meeting at the White House set to kick things off. But we emphasize that an early resolution remains uncertain. Both parties remain far apart on how they'd like to deal with the debt ceiling and in some ways haven't formed consensus within their own parties on the issue either. So the negotiating dynamic is likely to be tricky. That in turn means a range of policy solutions are plausible here, including a temporary suspension of the debt ceiling, unilateral measures by the administration to avoid default, a budget austerity package in exchange for raising the debt ceiling, or perhaps a clean debt ceiling raise.

Of course, that level of uncertainty is generally not something markets like. Not surprisingly, we're seeing further inversion of the yield curve for Treasury bills, with notes maturing in June rising to around 5.3%. However, it does dovetail with our general preference for bonds over equities in developed markets this year. If the negotiation lingers too long, investors could become more concerned about the impact of the economic growth outlook, either because payment prioritization puts government transfer payments at risk or budget austerity reduces the trajectory of net government spending. In that case, equity markets could come under pressure, but longer maturity bonds could benefit.

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