Once again, the debt ceiling is in the news and is a cause for concern. If the debt ceiling binds, and the U.S. Treasury does not have the ability to pay its obligations, the negative economic effects would quickly mount, triggering a deep recession. Although the US government has never defaulted on its debt, it does occasionally have showdowns over whether or not the ceiling will be raised.
Tense negotiations last took place in 2011 and 2013; US fiscal agencies estimate that these stand-offs pushed total borrowing costs up by $19 billion and $38 billion respectively. Risks to the economy are even bigger this time, given that the US is on the edge of a slowdown and rising interest rates have already strained the banking system.
There is a high degree of uncertainty over how debt-ceiling talks will play out. The most likely outcome is that a debt-ceiling agreement is reached just prior to the default deadline. The Treasury will probably have enough funds to stretch for a few days or even weeks, but passing the symbolic June 1st date without an agreement would still destabilize markets. This scenario will have a range of economic consequences.
Bond yields are expected to rise across the board, potentially 25-50 basis points above current levels—similar to the effects of the 2011 debt stand-off. The US dollar is likely to depreciate modestly against major currencies over the next month as investors anticipate higher economic and financial risks. The dollar’s value is, to a large extent, based on global demand for US dollar-denominated securities, which would also soften. There is a high risk that credit rating agencies would downgrade the US rating, permanently raising borrowing costs and deepening the economic slowdown.
If leaders cannot reach an agreement by then, the next most likely alternative is that they would lift the debt ceiling marginally, delaying final negotiations until September. For this outcome to be viable, Democrats and Republicans would have to have fleshed out the structure of an agreement by June, with only the final details left to be negotiated after the debt ceiling is temporarily raised.
This outcome would have a slightly more negative effect on the economy in June-September than our baseline scenario. The 2024 budget negotiations are expected to be even more fraught than usual, given the current level of partisan tensions. This increases the risk of a temporary government shutdown as both parties fight overspending plans. Adding the debt-ceiling question to the mix would aggravate investor fears. Relative to our baseline, this would weigh on asset prices and the US dollar, as well as raise bond yields and market volatility.
If no agreement on the debt ceiling has been reached by the time the Treasury runs out of funds, the US government could prioritize payments to bondholders by cutting spending elsewhere (for example, by pausing public investments or shutting down “non-essential” departments and services, such as National Parks). The government would protect essential payments, such as Social Security and Medicare payments (public pension and health services for retirees).
This prioritization would allow the government to continue meeting its debt payments for a short time, avoiding some of the worst financial and economic effects. However, this still amounts to a default, and it would seriously undermine US creditworthiness. In this case, we would expect the value of the dollar to fall sharply. Bond yields would probably rise by a larger margin than previously anticipated while the US is technically in default; even once the crisis is resolved, borrowing costs would remain elevated. Asset prices would drop sharply as economic fears mount. The US’s credit rating would be downgraded, which would keep the dollar weaker, and bond yields higher than they were prior to the debt crisis.