Some Thoughts on U.S. Fiscal Policy

INTRODUCTION

The U.S. Congress has a big "To Do" list shaping up. Markets seem pretty sanguine that we can avoid another shutdown but that doesn't mean it's going to be smooth sailing. Here, we outline the likely outcomes and their implications for the markets. In short, the risk of a default or catastrophic outcomes remains mostly hyperbole. Moreover, markets have already incorporated a smaller overall fiscal stimulus compared to what was assumed earlier in the year.

RECENT DEVELOPMENTS

The August 2019 suspension of the US debt ceiling expired last month. This means that the ceiling was reset August 1 at $28.4 trln. A dysfunctional Congress has been tasked with a compromise that heads off a potential technical default when current extraordinary measures taken by Treasury Secretary Yellen run out sometime next month.

Yellen has warned her department that it will run out of cash October 18 unless Congress passes the necessary legislation. This has become the new effective deadline for passing a bill that addresses the debt ceiling and provides funds to keep the government running and to meet all its obligations. FY21 ends September 30 and it's not unusual to have to pass a so-called Continuing Resolution that will keep the government running until the full FY budget has been passed. However, when this runs up against the debt ceiling, things can get quite tense.

Republican Senators just rejected the bill submitted by Democratic lawmakers. The bill would have suspended the debt ceiling until December 2022 and funded the government past September 30. Over the summer, the Democrats had a choice to make the debt ceiling vote part of the budget reconciliation process that would not require any Republican support but instead insisted on a bipartisan approach. That might have worked ten years ago but the mood on Capitol Hill is very different now.

Wrangling over the infrastructure and "human infrastructure" bills continues. Centrist Democrats are balking at the $3.5 trln price tag, forcing House Speaker Pelosi to try and reach a compromise number. Meanwhile, progressive Democrats are vowing not to support the traditional infrastructure bill without having the "human infrastructure" bill pass first. This is a big gamble.

US FISCAL OUTLOOK

"To Do" List for Congress
1. Fund the government beyond September 30 - bipartisan support
2. Raise the debt ceiling beyond current $28.4 trln - no bipartisan support
3. Pass emergency disaster aid - bipartisan support
4. Pass infrastructure bill worth $1.2 trln - bipartisan support
5. Pass "human infrastructure" bill worth $3.5 trln - no bipartisan support

The first three were bundled together into the bill that the Republicans just rejected in the Senate. The most likely path now is that the debt ceiling is folded into the human infrastructure package that the Democrats plan to pass by the budget reconciliation process requiring no Republican support. As noted earlier, however, even the relatively straightforward and bipartisan infrastructure bill may fall victim to brinksmanship regarding the more partisan matters. Stay tuned.

INVESTMENT OUTLOOK

Despite official concerns about a shutdown leading to "catastrophe" and heightened risks to U.S. growth, we believe this is mostly hyperbole. The U.S . has survived many shutdowns in the past with little lasting consequence and we believe that holds true now as well. Moreover, markets have already downgraded the optimistic fiscal picture from earlier in the year in light of continued roadblocks from both Democrats and Republicans and President Biden's faltering support.

That said, any market movements linked to the debt ceiling battle are likely to be transitory. We retain our bullish call on the dollar and our bearish call on bonds. With yields rising, equity markets will face some headwinds but strong U.S. growth should help offset this.

Using the 2011 debt ceiling fight as an example, equities may be vulnerable near-term to potential U.S shutdown risks . The outlook for bonds and the dollar are not so clear-cut. The major ratings agencies have been strangely silent over the potential shutdown. Our read is that the agencies have a similarly sanguine view as the markets in that a resolution is highly likely. However, that is not always that case.

As we saw back in 2011, brinksmanship over the debt ceiling can have serious consequences. All three rating agencies moved the US outlook to negative during the 2011 debt ceiling fight. However, S&P was the only one to downgrade the US for the first time ever on August 5, 2011. The US was cut one notch to AA+, and the agency cited Washington gridlock as well as the lack of an agreement to contain the growing debt load for its decision to downgrade. S&P also noted then that no country has regained AAA in less than nine years.

US stocks sold off both before and after that downgrade. After posting a low for that move in early October 2011, US stocks then recovered and embarked on a multi-year rally that lasted until mid-2015 before a correction set in. If the U.S. can avoid a recession as we expect, we suspect this pattern may be repeated for this current debt ceiling battle.

The impact of potential downgrades on either the US Treasury market or the dollar is not so clear. After S&P downgraded the US in August 2011, the 10-year UST yield spiked temporarily but then went on to make new lows before reversing higher a year later. Similarly, the dollar softened slightly ahead of that downgrade but then went on a tear for the rest of the year and well into 2012.

Bottom line: given all the current uncertainty regarding the US economy and Fed policy, the last thing the markets need is an added dose of uncertainty regarding the debt ceiling and a potential technical default by the US. Our base case is that a last minute deal is struck but markets are likely to remain volatile ahead of that.

A BRIEF HISTORY LESSON

Shutdowns in the U.S. occur when Congress fails to pass funding legislation. If the so-called funding gap is not addressed via stop gap spending bills (continuing resolutions), the government is forced to shut down. Since the current appropriations process was put in place back in 1976, there have been a total of 22 shutdown resulting from funding gaps. The most memorable one was probably the 2011 shutdown since it led to a U.S. rating downgrade. However, many of us have the 2018-2019 shutdown as the most recent point of reference. Of note, the 35-day shutdown was the longest ever. While there were tangible economic and human costs involved, we do not feel that it qualifies as anything near "catastrophic."

How did the debt ceiling come about in the US? In the early days of the union, Congress typically issued debt for specific purposes. For instance, to build the Panama Canal or to fund the Spanish-American War. As World War I developed into an open-ended conflict, Congress decided it was simply easier to establish a general limit on borrowing. It did so with the First Liberty Loan Act of 1917, which established a $5 bln limit on new bond issuance as well as the immediate issuance of $2 bln in one-year certificates of indebtedness (later replaced by T-bills).

As the costs of WWI grew, it was necessary for Congress to pass the Second Liberty Bond Act of 1917. That increased the limits to $9.5 bln for Treasury bonds and $4 bln for 1-year certificates of indebtedness. By the end of WWI in November 1918, the total limit had been raised to $43 bln, which compared to the $25 bln of outstanding public debt in 1919.

After WWI, all increases to the national debt were made as amendments to the Second Liberty Bond Act. In 1939, Congress created an overall aggregate limit on the national debt rather than on various maturities and the debt ceiling as we know it was born. In principle, the ceiling was meant to make life easier for Congress. Indeed, for the first 10-15 years, it was raised without controversy or incident.

Instead, it has become a political sledgehammer. The first debt ceiling fight began in 1953, when President Eisenhower faced a revolt by the Republican-controlled Senate. Eisenhower wanted more funding to build the national highway system, but Congress had become alarmed at the buildup in the national debt during WWII. After much wrangling and some emergency measures taken by Treasury, the debt ceiling was raised in 1954. It turns out that the ceiling has very little real meaning, having been raised more than 80 times since 1959
under administrations from both parties.

Starting in 2013, Congress has temporarily suspended the debt limit rather than raising it directly. This has been done five times. A suspension allows Treasury to borrow as needed during that time to meet all its obligations in full and on time. When the suspension ends, the amount borrowed during that suspension is added to get the new ceiling. The debt ceiling was $20.456 trln when it was suspended back in February 2018. It went back into effect in March 2019, with the new ceiling established at $22 trln.

With the ceiling is reached, the Treasury cannot issue any new debt. However, as we've seen in the past, that doesn't mean that the government can no longer fund itself. Through various accounting tricks, Treasury is able to continue making payments by so-called "extraordinary measures." As those measures become exhausted, however, there is increased risk of a technical default. That is where we stand now.

The 2011 fight over the debt ceiling is worth mentioning. This was widely regarded as the first time that the debt ceiling was utilized in a partisan manner in a fight about budget policies. The showdown took place as the new Republican House came into power after the November 2010 midterm elections. A "clean" bill that would raise the ceiling with no strings attached was soundly defeated in the House 318-97 on May 31.

Eventually, the House was able to force spending cuts of $900 bln over ten years in exchange for an increase in the debt ceiling. This compromise was contained in the Budget Control Act of 2011, which passed in the House August 1 by a vote of 269-161 and in the Senate August 2 by 74-26. Even though a shutdown was avoided, the drama still led to the first ever downgrade for the US by S&P on August 5.

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