Executive Summary

The U.S. Treasury is currently utilizing extraordinary measures to create additional borrowing capacity for the federal government as it operates up against the $22 trillion debt limit. Eventually, these measures will be exhausted, and our current baseline projection is that they will be exhausted sometime early in October, though we think there is a risk they could run out in late August instead.

We expect that the debt ceiling will be eventually resolved in time to prevent a default. That said, a technical or de facto default, should one occur, would have destabilizing financial market and economic implications. A fiscal fumble from policymakers in Washington, D.C. represents a risk to the economic outlook later this year. In this report, we take a dive into what the debt ceiling is, how long the Treasury can maneuver while up against it and what might happen in a brush with default.

 

First Things First: What Is the Debt Ceiling?

In short, the debt ceiling is a statutory limit on the borrowing authority of the federal government. Thus, when the debt ceiling is set to roughly $22 trillion as it is now, total public debt cannot rise above that number (hence the "ceiling", Figure 1). Since the United States has for the most part run budget deficits in recent history (Figure 2), the debt ceiling periodically has to be raised in order to accommodate additional borrowing by the federal government. Why does the debt ceiling even exist in the first place? Prior to 1917, Congress had to approve each individual offering when the Treasury needed to issue debt, right down to the interest rate offered. When the United States decided to enter World War I, this method of debt issuance became unwieldy, so Congress created the debt ceiling to give the Treasury more discretion while also ensuring that the legislative branch retained a degree of control over how much could ultimately be borrowed.

Special Commentary

When Congress increases the debt ceiling, it essentially has two options: it can raise the debt ceiling to a specific number, creating a specific dollar amount of headroom for an indefinite amount of time, or it can simply suspend the debt ceiling until some future date, creating an unspecified amount of headroom for a definite amount of time. When policymakers follow the second route, as they have frequently done of late, the debt ceiling is reinstated on a specified date at whatever dollar amount of public debt prevails on that day. Most recently, on February 9, 2018, Congress suspended the debt ceiling until March 1, 2019. After this period elapsed, the statutory debt limit was permanently increased $21.99 trillion, or the amount of public debt outstanding on March 2.

Ostensibly, when the debt ceiling is reinstated, it should quickly become a hard deadline because the government runs a budget deficit. With a debt ceiling in place, the Treasury could not last very long before its negative cash flow would burn through the cash on hand. This is where the "extraordinary measures" come into play. When Congress fails to lift the borrowing limit, the Treasury utilizes a set of "extraordinary measures" to temporarily keep the nation under the borrowing limit, primarily by halting investments in select government funds.1 By halting these investments, headroom is created under the cap, permitting the Treasury to borrow from the public.

 

How Long Do Extraordinary Measures Last?

With extraordinary measures available, the true "X date", or when the Treasury would be unable to meet all of its obligations on time, lies at some later date from when the debt ceiling is actually hit. But how long can these extraordinary measures last? This is the magic question tackled by public and private analysts alike each time a debt ceiling deadline approaches. Estimating how long the Treasury can operate while constrained by the debt ceiling is essentially a function of three things: the cash on hand the Treasury has when the debt ceiling is reinstated, the size of the extraordinary measures available to the Treasury and the Treasury's projected operating cash flow.

When the debt ceiling is suspended, the Treasury is required by law to wind down its cash balance by the day of reinstatement to the level that prevailed when the debt ceiling was suspended, which in this most recent case was about $200 billion. The size of the extraordinary measures available to the Treasury varies depending on the time of year but is usually known with a decent degree of precision. Estimating the government's cash flow is the trickiest piece of the puzzle, as it is subject to considerable uncertainty for a host of reasons, including uncertainty in the economic outlook, policy changes and calendar quirks.

The other key point to understand when forecasting the X date is that the distribution of revenue and outlays is not evenly distributed. Generally speaking, the first and last days of each month often see the largest net outflows due to large payments that are due at that time (Figure 3). For example, payments to Medicare Advantage and Medicare Part D plans are made on the first day of the month and average almost $30 billion. The mid-month period sees the biggest net inflows on average, largely due to individual tax-filing day falling in mid-April and quarterly corporate tax payments falling in mid-January, April, June, September and December (for any given company, the specific four quarters depend on that company's fiscal year). Thus, once again speaking at a high level, the X date is more likely to fall at the beginning or end of a month than in the middle.

Special Commentary

Our analysis of these factors suggests that there are two possible outcomes. The first, and what we consider the most likely outcome, is that the X date falls in the first week of October. The end of tax season has brought the Treasury's cash balance to more than $400 billion, giving it a war chest with which it can finance the budget deficit without resorting to additional borrowing. Corporate tax payments due in June and September should also help the Treasury stay afloat. By the end of September, however, this cash on hand will likely have been mostly exhausted, and large payments due at the start of October/start of the new fiscal year could threaten the government's implicit solvency.

The second outcome, and one we consider less likely but still plausible, is that the X date falls in August, which was our original projection back in January. July and August are "down" months for the federal budget deficit (Figure 4), and the late August/early September period could get tricky as the Treasury tries to remain afloat until the mid-month corporate tax payments are made in September. At this point in time, we think the Treasury will be able to make it through, but any unexpected developments that negatively impact the deficit outlook could be enough to tip the scales. Were the economic outlook to deteriorate significantly, for example, weaker tax collections and larger outlays could lead to a wider-than-expected deficit. Congress also continues to wrangle over a disaster spending bill for a variety of recent natural disasters. If the total were to be significantly higher than expected, this could also change the X date outlook.

Special Commentary

Congress could of course increase the debt ceiling well before then, eliminating the need for any debt ceiling brinksmanship. Based off of the timing of the X date projections, however, it appears increasingly likely the debt ceiling will be tied to the FY 2020 budget process. FY 2020 begins on October 1, and lawmakers still need to set top-line spending levels and pass the bills appropriating the money. As a result, the budget fight and the debt ceiling may all be tied together come September. As always, we will update our readers should anything occur that would materially change our outlook.

 

What Happens in a Brush with Default?

The August 2011 debt ceiling showdown was perhaps the closest brush the United States has had with the X date. During that period, the U.S. Treasury projected that the X date would fall on August 2, and it was on that day exactly that Congress passed and President Obama signed a bill into law increasing the debt ceiling. Consumer confidence weakened significantly during the debt ceiling showdown (Figure 5), and a closely watched measure of U.S. economic policy uncertainty touched its highest level on record (Figure 6). Although it is difficult to parse out how much, if at all, the debt ceiling impasse was to blame, it is worth noting that real GDP growth was an especially weak -0.1% on a quarter-over-quarter annualized basis in Q3-2011.

Special Commentary

A key question that comes up each time a hard debt ceiling deadline looms is whether or not the Treasury could prioritize payments, specifically whether it could prioritize principal and interest payments on Treasury securities to avoid a technical default.2 To this day, the jury is still out on whether this is legally or technically possible. The debate goes back as far as the mid-1980s, when the Treasury and the Government Accountability Office (then called the General Accounting Office) disagreed over whether Treasury must make payments on obligations as they come due. It has been the general custom of Treasury officials to squash the notion that prioritization is a viable option.

Most recently, Treasury Secretary Steven Mnuchin told lawmakers he had "no intent" to prioritize certain government payments and delay others if Congress fails to raise the debt ceiling.3

A 2012 report by the Council of Inspectors General on Financial Oversight (CIGFO) on the previous year's debt ceiling debacle noted that "Treasury officials determined that there is no fair or sensible way to pick and choose among the many bills that come due every day. Furthermore, because Congress has never provided guidance to the contrary, Treasury's systems are designed to make each payment in the order it comes due."4 In 2014, however, Treasury Assistant Secretary Fitzpayne stated in a letter that "if the debt limit was reached and sufficient cash was available, the Federal Reserve Bank of New York would be technologically capable of continuing to make principal and interest payments on the debt."5 The transcripts from a conference call among Federal Reserve officials on August 1, 2011 suggest that prioritization was seriously under consideration at the time, and that from a technological standpoint, the bigger concern was about the capabilities of the New York Fed's counterparties rather than the New York Fed itself.6

In short, should the X date come to pass without a debt ceiling resolution, it is not exactly clear what the Treasury would do or whether such a prioritization plan could be executed without a glitch. Even though Treasury officials have tried to stress that prioritization is not a viable option, it does appear the option has been studied and discussed as a "break the glass" option in an emergency. Setting aside the legal and technical challenges, the political repercussions would likely be tremendous. Choosing to pay bondholders would delay payments due to other recipients of federal spending. And even if prioritization were utilized, it is not immediately clear to us that making principal and interest payments on time would be enough. Under a prioritization scenario, the federal government would still be unable to meet all of its obligations on time, and financial market participants may not distinguish between a technical and a de facto default.

What might the financial market reaction be to another close call? Given what has happened in past debt ceiling showdowns, we believe that an immediate de-risking in financial markets would occur, which likely would push policymakers rapidly towards a resolution before the consequences of a genuine default in Treasury securities could be felt. Turning back to the 2011 episode, the S&P 500 fell nearly 17% between July 22 and August 8 (Figure 7). The reaction in the Treasury market was a bit more nuanced. Ostensibly, concern about the fiscal outlook and the solvency of the U.S. government should put upward pressure on yields on Treasury securities. The yield on the 10-year Treasury, however, fell 85 basis points between July 28 and August 3, in-line with the significant "risk-off" move that occurred during this stretch. In contrast, yields on very short-dated Treasury securities rose as the near-term risk of owning a security that could be in default caused investors to shift their money elsewhere (Figure 8). During that August 1 conference call of the Federal Reserve Board, Brian Sack, the Manager of the System Open Market Account (SOMA) at the time, noted that:

Special Commentary

"Money market funds and other market participants began to hoard significant amounts of liquidity. In that process, they moved out of short-term Treasury repo transactions and Treasury bills and into deposits at financial institutions, reflecting their concern that the Treasury markets could become increasingly dysfunctional."7

For financial market participants looking for a port in the storm, it appears the "where to go" question was answered, at least in part, by putting money on deposit at financial institutions.

A related risk for markets would be the possibility of another downgrade of the federal government's credit rating. In the wake of the 2011 debt ceiling episode, Standard & Poor's downgraded the U.S. sovereign credit rating from AAA (its highest rating) to AA+. At the time, the Federal Reserve deliberated about whether this downgrade from the ironclad AAA would force investors to dump Treasuries. The transcript from the aforementioned FOMC conference call noted that "It is difficult to calibrate just how much the market would react to an actual downgrade by S&P. Our judgment is that a move to AA or AA+ rating would not force many investors to have to sell Treasury securities because of their investment mandates."8 On the day of the downgrade, the 10-year yield jumped 15 basis points to 2.56%. Nearly eight years later, however, the yield on the 10-year is nearly identical, suggesting that there are still plenty of investors demanding U.S. Treasuries. Another downgrade, however, could signal that the 2011 episode was not a one-off event to be ignored and could awaken financial market participants to the serious fiscal challenges that lie ahead.

What might be the economic and financial market implications of actually entering a default period? Peering beyond the veil of the X date is to a large extent speculation, since policymakers have always found a way to lift the debt ceiling before the point of insolvency. A default could lead to both voluntary and involuntary selling of Treasuries, leading to a sell-off. Yet, it is not immediately clear where investors could safely turn. To U.S. mortgage-backed securities, which contain an implicit government guarantee? To municipal debt, whose finances are often intertwined with federal grants and loans? Perhaps foreign sovereign debt like German bunds would be the answer, but the outsized U.S. Treasury market, at $16 trillion, dwarfs that of most other countries. The market for German bunds, for instance, is a bit less than $1.5 trillion. As mentioned earlier, U.S. banks saw large deposit inflows during the 2011 episode, but here too the interconnectedness of the financial system shows: a large chunk of these deposits ended up at the Federal Reserve, the fiscal agent of the federal government and the largest U.S. Treasury holder in the world! Such a default scenario, should it come to pass, would likely have significant destabilizing and negative economic consequences for the U.S. and global economies.

 

Conclusion

Pulling it all together, the U.S. Treasury is currently utilizing extraordinary measures to create additional borrowing capacity for the federal government as it operates up against the debt limit. Eventually, these measures will be exhausted, and our current baseline projection is that they will be exhausted sometime early in October, though we think there is a risk this could occur in late August instead. Congress and the president could act at any point to lift the debt ceiling, but it appears increasingly likely the debt ceiling will be tied to the FY 2020 budget, which may not be resolved for several more months. As a result, it is possible there could be some debt ceiling brinksmanship come the late summer/fall. Should it occur, financial markets could see a significant risk-off move, and the economic disruptions would be another challenge for an expansion that, in a few more months, will be the longest on record.

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Recently, the stock market has experienced high levels of volatility. If you are thinking about participating in fast moving markets, please take the time to read the information below. Wells Fargo Investments, LLC will not be restricting trading on fast moving securities, but you should understand that there can be significant additional risks to trading in a fast market. We've tried to outline the issues so you can better understand the potential risks. If you're unsure about the risks of a fast market and how they may affect a particular trade you've considering, you may want to place your trade through a phone agent at 1-800-TRADERS. The agent can explain the difference between market and limit orders and answer any questions you may have about trading in volatile markets. Higher Margin Maintenance Requirements on Volatile Issues The wide swings in intra-day trading have also necessitated higher margin maintenance requirements for certain stocks, specifically Internet, e-commerce and high-tech issues. Due to their high volatility, some of these stocks will have an initial and a maintenance requirement of up to 70%. Stocks are added to this list daily based on market conditions. Please call 1-800-TRADERS to check whether a particular stock has a higher margin maintenance requirement. Please note: this higher margin requirement applies to both new purchases and current holdings. A change in the margin requirement for a current holding may result in a margin maintenance call on your account. Fast Markets A fast market is characterized by heavy trading and highly volatile prices. These markets are often the result of an imbalance of trade orders, for example: all "buys" and no "sells." Many kinds of events can trigger a fast market, for example a highly anticipated Initial Public Offering (IPO), an important company news announcement or an analyst recommendation. Remember, fast market conditions can affect your trades regardless of whether they are placed with an agent, over the internet or on a touch tone telephone system. In Fast Markets service response and account access times may vary due to market conditions, systems performance, and other factors. Potential Risks in a Fast Market "Real-time" Price Quotes May Not be Accurate Prices and trades move so quickly in a fast market that there can be significant price differences between the quotes you receive one moment and the next. Even "real-time quotes" can be far behind what is currently happening in the market. The size of a quote, meaning the number of shares available at a particular price, may change just as quickly. A real-time quote for a fast moving stock may be more indicative of what has already occurred in the market rather than the price you will receive. Your Execution Price and Orders Ahead In a fast market, orders are submitted to market makers and specialists at such a rapid pace, that a backlog builds up which can create significant delays. Market makers may execute orders manually or reduce size guarantees during periods of volatility. When you place a market order, your order is executed on a first-come first-serve basis. This means if there are orders ahead of yours, those orders will be executed first. The execution of orders ahead of yours can significantly affect your execution price. Your submitted market order cannot be changed or cancelled once the stock begins trading. Initial Public Offerings may be Volatile IPOs for some internet, e-commerce and high tech issues may be particularly volatile as they begin to trade in the secondary market. Customers should be aware that market orders for these new public companies are executed at the current market price, not the initial offering price. Market orders are executed fully and promptly, without regard to price and in a fast market this may result in an execution significantly different from the current price quoted for that security. Using a limit order can limit your risk of receiving an unexpected execution price. Large Orders in Fast Markets Large orders are often filled in smaller blocks. An order for 10,000 shares will sometimes be executed in two blocks of 5,000 shares each. In a fast market, when you place an order for 10,000 shares and the real-time market quote indicates there are 15,000 shares at 5, you would expect your order to execute at 5. In a fast market, with a backlog of orders, a real-time quote may not reflect the state of the market at the time your order is received by the market maker or specialist. Once the order is received, it is executed at the best prices available, depending on how many shares are offered at each price. Volatile markets may cause the market maker to reduce the size of guarantees. This could result in your large order being filled in unexpected smaller blocks and at significantly different prices. For example: an order for 10,000 shares could be filled as 2,500 shares at 5 and 7,500 shares at 10, even though you received a real-time quote indicating that 15,000 shares were available at 5. In this example, the market moved significantly from the time the "real-time" market quote was received and when the order was submitted. Online Trading and Duplicate Orders Because fast markets can cause significant delays in the execution of a trade, you may be tempted to cancel and resubmit your order. Please consider these delays before canceling or changing your market order, and then resubmitting it. There is a chance that your order may have already been executed, but due to delays at the exchange, not yet reported. When you cancel or change and then resubmit a market order in a fast market, you run the risk of having duplicate orders executed. Limit Orders Can Limit Risk A limit order establishes a "buy price" at the maximum you're willing to pay, or a "sell price" at the lowest you are willing to receive. Placing limit orders instead of market orders can reduce your risk of receiving an unexpected execution price. A limit order does not guarantee your order will be executed -" however, it does guarantee you will not pay a higher price than you expected. Telephone and Online Access During Volatile Markets During times of high market volatility, customers may experience delays with the Wells Fargo Online Brokerage web site or longer wait times when calling 1-800-TRADERS. It is possible that losses may be suffered due to difficulty in accessing accounts due to high internet traffic or extended wait times to speak to a telephone agent. Freeriding is Prohibited Freeriding is when you buy a security low and sell it high, during the same trading day, but use the proceeds of its sale to pay for the original purchase of the security. There is no prohibition against day trading, however you must avoid freeriding. To avoid freeriding, the funds for the original purchase of the security must come from a source other than the sale of the security. Freeriding violates Regulation T of the Federal Reserve Board concerning the extension of credit by the broker-dealer (Wells Fargo Investments, LLC) to its customers. The penalty requires that the customer's account be frozen for 90 days. Stop and Stop Limit Orders A stop is an order that becomes a market order once the security has traded through the stop price chosen. You are guaranteed to get an execution. For example, you place an order to buy at a stop of $50 which is above the current price of $45. If the price of the stock moves to or above the $50 stop price, the order becomes a market order and will execute at the current market price. Your trade will be executed above, below or at the $50 stop price. In a fast market, the execution price could be drastically different than the stop price. A "sell stop" is very similar. You own a stock with a current market price of $70 a share. You place a sell stop at $67. If the stock drops to $67 or less, the trade becomes a market order and your trade will be executed above, below or at the $67 stop price. In a fast market, the execution price could be drastically different than the stop price. A stop limit has two major differences from a stop order. With a stop limit, you are not guaranteed to get an execution. If you do get an execution on your trade, you are guaranteed to get your limit price or better. For example, you place an order to sell stock you own at a stop limit of $67. If the stock drops to $67 or less, the trade becomes a limit order and your trade will only be executed at $67 or better. Glossary All or None (AON) A stipulation of a buy or sell order which instructs the broker to either fill the whole order or don't fill it at all; but in the latter case, don't cancel it, as the broker would if the order were filled or killed. Day Order A buy or sell order that automatically expires if it is not executed during that trading session. Fill or Kill An order placed that must immediately be filled in its entirety or, if this is not possible, totally canceled. Good Til Canceled (GTC) An order to buy or sell which remains in effect until it is either executed or canceled (WellsTrade® accounts have set a limit of 60 days, after which we will automatically cancel the order). Immediate or Cancel An order condition that requires all or part of an order to be executed immediately. The part of the order that cannot be executed immediately is canceled. Limit Order An order to buy or sell a stated quantity of a security at a specified price or at a better price (higher for sales or lower for purchases). Maintenance Call A call from a broker demanding the deposit of cash or marginable securities to satisfy Regulation T requirements and/or the House Maintenance Requirement. This may happen when the customer's margin account balance falls below the minimum requirements due to market fluctuations or other activity. Margin Requirement Minimum amount that a client must deposit in the form of cash or eligible securities in a margin account as spelled out in Regulation T of the Federal Reserve Board. Reg. T requires a minimum of $2,000 or 50% of the purchase price of eligible securities bought on margin or 50% of the proceeds of short sales. Market Makers NASD member firms that buy and sell NASDAQ securities, at prices they display in NASDAQ, for their own account. There are currently over 500 firms that act as NASDAQ Market Makers. One of the major differences between the NASDAQ Stock Market and other major markets in the U.S. is NASDAQ's structure of competing Market Makers. Each Market Maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the Market Maker will immediately purchase for or sell from its own inventory, or seek the other side of the trade until it is executed, often in a matter of seconds. Market Order An order to buy or sell a stated amount of a security at the best price available at the time the order is received in the trading marketplace. Specialists Specialist firms are those securities firms which hold seats on national securities exchanges and are charged with maintaining orderly markets in the securities in which they have exclusive franchises. They buy securities from investors who want to sell and sell when investors want to buy. Stop An order that becomes a market order once the security has traded through the designated stop price. Buy stops are entered above the current ask price. If the price moves to or above the stop price, the order becomes a market order and will be executed at the current market price. This price may be higher or lower than the stop price. Sell stops are entered below the current market price. If the price moves to or below the stop price, the order becomes a market order and will be executed at the current market price. Stop Limit An order that becomes a limit order once the security trades at the designated stop price. A stop limit order instructs a broker to buy or sell at a specific price or better, but only after a given stop price has been reached or passed. It is a combination of a stop order and a limit order. These articles are for information and education purposes only. You will need to evaluate the merits and risks associated with relying on any information provided. Although this article may provide information relating to approaches to investing or types of securities and investments you might buy or sell, Wells Fargo and its affiliates are not providing investment recommendations, advice, or endorsements. Data have been obtained from what are considered to be reliable sources; however, their accuracy, completeness, or reliability cannot be guaranteed. Wells Fargo makes no warranties and bears no liability for your use of this information. The information made available to you is not intended, and should not be construed as legal, tax, or investment advice, or a legal opinion.

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