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by  J.DonohueB.Swensen, CFA Apr 24, 2023

Debt Ceiling - History Repeating

  • The circumstances are similar to 2011 and 2013, but there are key differences
  • Lessons learned from the past inform our expectations for today
  • We’re really talking about the potential for a significant liquidity event
  • Focus on how to manage and potentially benefit from the coming volatility

View transcript

Hello and welcome to the RBC Global Asset Management Navigator Podcast. My name is John Donohue, head of RBC Banking Channel and Liquidity Management. Today I'm joined by my colleague Brandon Swensen, Senior Portfolio Manager on the BlueBay US Fixed Income Team. In today's episode of the Navigator Podcast, we're going to discuss our view on the current situation in the US.

Related to the debt ceiling showdown that is quickly approaching. Brandon, thank you for being with us today. We look forward to hearing your thoughts on the different potential scenarios that may play out as the government tries to solve this minefield. It's amazing. Over our 20 plus year career, it seems like there's always something to navigate, pun intended, in order to safeguard and maximize client assets.

Whether it was early in our career with the Asian financial crisis, corporate fraud we saw with Enron and select others 911 the global financial crisis of 2008, a pandemic aggressive easing. And now we're an environment facing the ramifications of an aggressive Fed tightening cycle. Silicon Valley Bank and Credit Suisse strains. And now to what feels a little deja vu to last major debt ceiling issues of 2011 and 2013.

As we know, although sometimes it feels the same with distinct similarities. There is always something different to evaluate, prepare for, and having these past experiences as you do is a key advantage. Today, I'd like to accomplish a few things. Share with the audience some of the questions and concerns that are top of mind for clients today. The simple background concerning the debt ceiling situation and ultimately the implications for markets and how investors should be thinking about their portfolio.

Let me set the stage for our listeners. The US debt ceiling is the statutory limit on the amount of money the US government can borrow to pay for everything that is already approved spending on. Earlier this year, we hit that limit. And while the government can fund itself for some time, we're now fast approaching the point where these extraordinary funding methods will run out.

So, we're interested to hear your insights on how you and the RBC team are navigating this market. So let's begin with the first question. Simply put, what is the current timeline for the debt ceiling limit to be hit by the Treasury?

Of course, John. But before I answer that quick, that was quite a walk down memory lane you just provided for us, you know, thinking through each one of those. I think it helps frame the context because we have been through this before. We've seen two episodes that were particularly acute with the debt ceiling.

So I think that's going to help inform a lot of what we talk about today and a lot of what I think, you know, investors and clients can take away from the conversation and some of the thoughts that we have relating to the current situation that we're faced with, as we approach this date that you just asked me about, the timeline that we're talking about is somewhat uncertain at this point.

But we did get a very important bit of data just recently with the personal tax receipts from the U.S. Treasury. Those came in a bit lower than we had seen previously in previous years. But I would say not too far off from what was expected so that the data, as you've talked about with the debt ceiling.

It really comes down to when will the Treasury run out of money and when will the Treasury tell us that date is. So, the personal tax receipts was one important number. The next one comes in June with corporate tax payments when those come in. So right now, given, as I mentioned, the U.S. personal tax receipts were a little bit on the lighter side, the date is being moved up a bit. So current best estimates are sometime probably in July. We still don't have a very tight band around the date that that could occur. But again, I think with the tax receipts that we saw from the personal side post tax-day in April, we were thinking it's going to be nearer rather than farther away.

In terms of the timeline, not expecting it to be an August or September event, although August is still, I think, in that window, but primarily focused on July for a potential timeline for when this will happen. This is also kind of interesting as we turn to sort of the dynamics about increasing the debt ceiling, because that shortens the time frame that Congress has to work with in order to get a deal approved and move through so that it could ultimately be signed by the White House.

Thank you for the kick-off. And you and the team recently published a paper called “Is History Repeating?” And as I introduced in the memory lane comments, just maybe go through a little bit of how those similar episodes played out and then how you take that experience and tie that forward to the current situation.

Like I said, I think there's a few positives that we can bring up around the debt ceiling and I think one of them absolutely is that we have seen this movie before. The first time you go through it, it’s like seeing an interesting movie for the first time.

It's all new. It's that you don't know how it's going to end. You don't know really what's going to happen. And that was 2011. I think looking back at all the debt ceiling negotiations that have occurred through the years, 2011 was the most acute. In that environment, we saw a very similar setup to what we have today in terms of a very divided Congress, particularly in the House.

A lot of demands coming from the Republican leadership in the House around reducing spending, reducing debt levels, attaching all kinds of conditions to increasing the debt ceiling back in 2011. This is exactly the playbook that they were following to try to get concessions because they really didn't have any power beyond their control of the House back then, much like the much like today.

With 2011, again, I think it was primarily because we were still a little bit in the shadow of the great financial crisis, as you brought up. So, markets were still a little bit more on edge back then, but we did certainly see a strong and dramatic response from financial markets to the brinksmanship and taking things right up to the final days where there was concern about the Treasury defaulting.

So, what happened was, equity prices had a significant correction. Credit spreads widened out materially. You saw S&P downgrade the credit rating of the added status from eight plus. So those are pretty significant moves in terms of how the market handled that first experience. You know, again, not necessarily expecting to see a similar response this time, but it's worth considering in terms of the similar dynamics within the political landscape.

Now, 2013 was our second go around with the debt ceiling and with brinksmanship and with difficulties getting politicians on the same page in terms of the need to increase it. That one certainly also impacted the markets. But if you look back in history and you look at how the equity market responded, how the bond market responded, particularly the credit markets, it was much less severe in terms of the moves and it wasn't nearly as long lasting either.

The volatility that you had was certainly in play, but it wasn't nearly to the extreme that we saw in 2011 where the equity draw down and the widening of credit spreads really took quite a long time to recover back to pre-debt ceiling levels. So, 2013 was a bit more of an issue, though, in terms of the way that they resolved that debt ceiling limit, I think is perhaps maybe one of the things we're looking to this time around to see if they follow a similar path because what they did in that instance was, they did some short-term extensions of the debt ceiling.

They knew they weren't going to get all parties to agree at the time. 2011 still being fresh in the memories of Congress. They didn't take it necessarily to a point where they wanted to default or they wanted to get all their demands met. So, they're able to amend and extend sort of the negotiation.

And they kicked the can down the road a few times before they ultimately were able to get a more long-lasting extension. But again, to a lot of us, particularly in the money market space, we just kept watching the goalposts get moved further and further down. But I think the good news there is, while we did have some stress, and some uncertainty and concerns and risks we were monitoring closely in 2013, the way that they went about managing it, I think is perhaps instructive for this time around as well. We even heard some early inklings from Congress about if we can't get the Republicans all on the same page, for example, around the reductions in spending, could it be extended? And there's already been a few members of Congress talking about trying to extend the debt ceiling to some shorter timeframe so that that potentially could be a playbook that you see from 2013 reemerge again in this episode.

You know, Brendan, this is this is great call and let me take you back to 2011 for a minute. You think about that time and you describe the volatility pick up. And in 2011, the impasse and divide was so great that the spike in equity volatility was 200% at the time. And then you talked about the drawdown in equity markets.

For a short period of time, from July 7th to August 8th, the S&P 500 was down 17%. And then the underperformance that you saw hit sectors such as defense, healthcare and information technology, among others. I guess my leading question here is that thankfully we haven't seen that type of move. It leads to the question, do you think that Wall Street is underestimating the risk of the situation?

Well, that's a very active and legitimate debate that investment teams around the globe are having, because it certainly looks on the surface when you look at where the equity markets today, where you look at where credit spreads sit today, they're not pricing in a very bad outcome here. In terms of a US default, for example, and what that could potentially imply.

So, it looks a little bit like the set-up, as I talked about, being one of very high concern, the highest concerns since 2011. And we know what happened in 2011. But I think you also look at what happened in 2013 and you look at what happened in subsequent debt ceiling debates. And there's there is a path forward in one way or another.

So, I think having that balance and that debate across Wall Street around what will be the implications for a potential default or potential brinksmanship that can take this to a very uncomfortable place from a timing perspective. And so, yes, I think that, as you mentioned, you could certainly argue Wall Street is a little complacent given just where the level of markets today.

However, as I mentioned, this is the third time where we've been at this point where we have a lot of concern around the debt ceiling. And it's hard to see exactly how everyone's going to come together to move this forward. But again, we've seen it a couple of times. We know from previous experiences, while there was some damage, certainly in 2011 and it was longer lasting than 2013.

Again, none of this should be anything that permanently has a material long term impact on the US economy and US financial markets. I think we're going to turn to this in a little bit as we get closer to the date and as we as we get more clarity around when that date is, it becomes more of a liquidity event.

I think that's where liquidity is really one of those hard to specifically define factors within investing. But in terms of how much it costs to trade, how easy is it to trade securities, particularly the bond market is affected by this given the over-the-counter nature of bonds. In the way bonds trade, liquidity will become more challenged as markets get more concerned about when and how this will play out.

And liquidity is usually a shorter-term thing. It's not something if you're worried about an event three months from today, you're not necessarily worried about what you're going to do in three months. Today from a liquidity perspective, you need to start preparing and planning for that. But I think the idea of it being a liquidity event is one of the reasons why it's not front and center for Wall Street.

They're not concerned about it today per say. But again, the conversations about this, you know, the reason we're talking today is because every day we're getting a day closer to whatever that day is. And we still haven't seen really any signs from Washington, DC that there is a clear path forward. So that's what we're really waiting for and looking for and hoping to see continued progress made.

Great, Brendan. Let's go back just a tad and clarify a couple of things because there’s nomenclature here. And things that the audience may not be as familiar with in terms of this situation. If you could just clarify the difference between a default scenario, the liquidity event as you described, versus solvency as an investor, how they should kind of think about this?

I think that's a really important component of this debt ceiling issue that you bring up in terms of what is a default. I think, you know, typically within investing, when you think of a default and security, it's usually some sort of a corporate entity that has essentially filed for bankruptcy, that has run out of money that can't pay its bills. One way or another.

And the term default is used based on their inability to pay back their debt. And then there's some sort of a process. It kicks off usually with the bankruptcy court and the investors who have the claims on the debt of the company are paid some percentage of their par value or of the amount of bonds that they own.

But in this case, with the US government, we're not talking about a bankruptcy of the US government. It's not an ability to pay the debt off. It's what you would say is its willingness to pay, not the ability to pay. So it's the default of the US Treasury in question, which wherever that may be. If that were to occur around an X date, would be what we would call a technical default.

So not that again, not that the government doesn't have the money to make the payment. It's just that for technical reasons and in this case it's a breach of the debt ceiling, they are not able to make that payment that they otherwise certainly could. They certainly have the money to do so. They can print more money to pay their pay their debts off if needed.

It's really this issue of the $31.4 trillion debt ceiling, when will they hit that number? And then the implications for issuing new bonds, which that's really where the conflict comes in. They don't have the ability to issue new bonds. They normally issue new bonds and pay off the maturing bonds. And that's how the process typically works.

What's important about this is that it's not a bankruptcy situation where the investor holding a defaulted Treasury security isn't going to get paid their principal and interest. It's just a matter of when they will get paid that principal and interest. And so that's what creates the uncertainty, that's what creates the liquidity event. Because if, for example, if you're a public entity or some sort of an investor that is investing in short term Treasury securities, perhaps you have bills that you need to pay and have your investment program set up to time the maturities of your investments with the timing of the cash flows that you need to make in terms of paying your bills. If you have a maturity that you can't get access to that cash, then you end up with a sort of a cascading event. Now, there's not just the US Treasury in default, but you have other entities that are affected down the stream and plays itself out through all of the bills that the U.S. government has, including payments to Social Security recipients just on down the line.

So the idea of a default in this scenario is not one where investors are going to lose money. They're going to just lose access to their money. And that's where the liquidity event comes into play. But it can be self-fulfilling as well. As I mentioned, if someone is relying on those funds to arrive on a maturity date, let's just call the July 31st and the money does not end up in their bank account until sometime in August.

And they have payments that they're trying to make that then they end up having to delay or are unable to make. You can see the cascading effects that it has and then where that goes throughout the entire financial system. I think that's what we were really concerned about in 2011 because we hadn't really had this experience before. And so there's a lot of uncertainty and fear around how that would play out.

I can just tell you from the seat of managing government money market funds, for example, the idea that you can't own a Treasury bill, that's always been the risk free asset, as it's been called, throughout financial textbooks and through time, you looked at Treasury bills as the risk free asset. Well, that's no longer the case.

What can you invest in if it's not for a Treasury bill? And so that's a real difficult puzzle to solve for when you're managing very conservative, very safe investment programs. If you can't invest in Treasury bills, what can you invest in? That's the difficulty that we have. And I would say on that note, one big difference that we have this year for short term investors and particularly money market fund investors, is we have the Fed's reverse repo facility, which was not in place in 2011 or 2013.

That's something that is much newer in its construct. So, the liquidity environment for money market funds is much better today. And I think those downstream effects, what you worry about happening next, if the Treasury bills are not able to be repaid on time, what happens next? Being able to put money market assets to the Federal Reserve, being able to collateralize those with whatever securities the Fed has on their balance sheet, that is a big benefit to money market fund investors and just money markets in general.

Having that backstop of liquidity that we know will be there regardless of the Treasury being able to pay its bills on time or not.

Right. That's a great setup. As a bond investor, you've done a great job here today going through risk evaluation, risk evaluation, risk evaluation. And when there's a situation like this, those are the three first key tenants for sure. But now when you flip the script a little bit about the Fed repo program and things of that nature, what are some of the opportunities that present themselves in pockets of volatility such as this?

Well, opportunities that definitely is flipping the sort of thinking around in terms of how would you then look to perhaps benefit from the volatility. And really what we see the thing we didn't talk about around 2011 and 2013 was what happened to the rest of the Treasury market. The very front end of the Treasury market, the bills and notes that were maturing, you know, very close to that date or even some of the extensions of the date that we that we had to endure in the past.

Further out the curve, Treasuries rallied significantly. So, I think there's a couple of takeaways from that in terms of avoiding sort of these summer maturities. That's really one of the things we've been doing that's again, putting the risk cap back on, which is really hard for us in money markets to take that hat off. But keeping on that risk helmet, if you will, very tight around trying to manage around maturities around the state, but then extending duration into Treasury securities.

Further out the curve is one way to benefit and hedge your portfolio a little bit and improve your liquidity because those securities in the past traded very well and had a significant amount of demand for them as we barreled headlong into these states in the past, but then also just managing liquidity.

So again, it's maybe not answering your question directly in terms of what are the opportunities, but having that balance of having some investments further out the curve, but then also managing your liquidity very carefully. And if you are going to need liquidity or are you going to be making investment allocation decisions in late June to the end of July, at this point, if you have a need to do that, perhaps you move that ahead or you raise some liquidity ahead of time again, to avoid that period of time.

If you want to have this liquidity situation that we're really concerned about not impact your investment profile or your investment opportunity set either, you need to get things done ahead of it or perhaps delay until there's a resolution. Until markets have recovered. But again, that brings in the risk element of it. How will this play out and what will be the sort of timeline in terms of how bad do things get, and then when do things recover and start moving forward and based more on fundamentals and other things that we normally get to focus on within the financial markets and spreads.

If I hear you correctly, if you had an investor that was invested in short term credit and all of this noise and concerns around the debt ceiling, do you think it would impact investing in an industrial organization with a high credit rating in one or two years or anything of that nature that would be material from a portfolio perspective?

No, that would be where you would want to focus opportunities, as you mentioned. Where would you see value if spreads were to widen? And as you mentioned, those very high-quality industrial type companies, less cyclical in nature, for example, strong cash flows, companies have a really strong track record of servicing debt, managing their debt very conservatively.

Those would be absolutely opportunities that you would look to add exposure to given any market dislocation that that may be occurring, because we certainly haven't seen and wouldn't expect to see any material impacts to those high quality corporations that sell real things. They have real customers, they have real products that generate that cash flow.

A lot of times when you run into liquidity events and I think one of the more interesting opportunities within liquidity events from a from a bond investors perspective is that you end up seeing people sell what they can sell, not what they should sell.

When you get into these environments. And a lot of times what that is those high-quality blue-chip companies, bonds that are, you know, something that people tend to run towards in a time of stress, the flight to quality, they call it. A lot of times those are the securities that end up getting sold because they're not as impacted, for example, but they become more available, and they become more attractively priced.

If you have the liquidity and capacity to add exposure there.

Brandon, thank you for your time today and sharing your valuable insights. We've experienced market volatility so far in 2023 and it sounds like we're potentially heading for more. So, it's been timely to get your thoughts on how we are investing in turbulent times. Thank you to our listeners for tuning into this episode of The Navigator. It's been our pleasure.


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