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Issue 16: Debt Drama in Washington?

January 23, 2023

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What should investors make of the debt drama in Washington?

Climbing US debt has once again hit the limit
The US reached its $31.4 trillion borrowing limit on January 19th, prompting the Treasury to initiate “special” accounting measures to manage Federal cash flow and push out potential default on US debt approaching June. US borrowing now sits at roughly 100% of the country’s GDP, up from 78% in 2018 and just under 40% in 2008. Congress places statutory limits on the nation’s total debt that can only be raised with a majority vote in both the House and the Senate, which has sometimes set the stage for clashes on Capitol Hill. This time around, borrowing costs are elevated with interest rates at their highest in 15 years and Democrats have rejected any negotiation on the debt ceiling out of the gate, forcing Republicans to do some serious thinking as to how they’ll navigate the issue.


Republican squabbles could spread to debt ceiling deliberations
For their part, GOP lawmakers, who assumed a narrow majority in the House out of the 2022 midterms, are intent on forcing Democrats to the bargaining table while insisting that any agreement on raising the debt ceiling must come with spending cuts. Indeed, it was in part on the back of promises to GOP conservatives that he would press on the debt ceiling issue when the time came that Kevin McCarthy finally assumed the role of House Speaker after a fifteenth vote, amidst a battle that ranks as most heated since a Civil War era contest in the 1850s. Having predictably breached the debt limit, Republicans now confront a debate within their party as to where they’ll push for cuts. Allocations to defense and entitlements might be too politically important to use as bargaining chips, given the fragile balance of power on Capitol Hill. Wherever they choose to slash spending, if Republicans are intent on using the debt ceiling as a leverage this year, the party will need to masterfully message the move to voters, lest the political narrative run against them.


What does this all mean for investors?
Given the likelihood of ugliness in the debt ceiling drama unfolding this year, the Congressional game of chicken may once again raise fears of a US default, conjuring memories of the 2011 US debt ceiling crisis, in which US credit was downgraded by S&P for the first time in history. To be sure, if a default happened—even a mere ‘technical’ default—it would be catastrophic. Treasury yields jumped 60 basis points and remained elevated for several months in 1979, when a last-minute bump in the debt ceiling prompted the Treasury to miss payments on T-bills due to a glitch in processing of paperwork. That said, leaders of both parties recognize that the debt ceiling must be raised, there are ‘grownups in the room’ who understand the dire consequences of a default, and most key participants understand the risk of failing to reach an agreement. The most likely implication for investors, observed in prior episodes of debt ceiling gridlock, is an increase in volatility, both with respect to equities and Treasuries, that will finally give way when lawmakers resolve their differences and raise the debt limit, as they have done 45 times in the last 40 years.

Understanding the US dollar’s retreat

Why has the dollar been losing ground?
The US dollar spot index, a basket of leading global currencies tracked against the US dollar (indicated by ticker DXY and colloquially known by traders as “the Dixie”), touched a seven-month low last Wednesday, as market expectations increased that the Fed will soon rein in the pace of its tightening. In addition to moderating expectations for US interest rates, broad dollar weakness was a sign that global investors had less interest in buying greenbacks for investment into US markets, with America’s economy on shakier footing—as evidenced for example by a bigger-than-expected 1.1% YoY drop in US retail sales for December—and less demand for Treasuries as a safe haven asset, despite elevated yields. Accordingly, we have observed flows from developed to emerging markets in recent weeks, on expectations that the latter will do better in the recovery phase of the current cycle.

Figure 1 Bloomberg Dollar Spot Index

Trends have turned against the dollar
A combination of relatively compelling US yields amid Fed rate hikes and investors’ preference for the perceived stability of US assets during a tumultuous period were driving dollar strength in 2022, while recent dollar weakness is predicated on the reversal of these themes: the markets’ expectation that we’re nearing peak rates and mid-year easing, along with concern that US assets might not be the safest place to invest as America heads for a potential recession. If inflation continues to moderate and the Fed makes a dovish pivot, the dollar will likely extend its slide into the new year; the correction will be accentuated in the event policy divergence leads other markets (China seems a good candidate) to significantly outperform the US, attracting more flows and further weaking dollar demand.


But don’t count the greenback out in 2023
On the other hand, a rapidly depreciating dollar would tend to exacerbate US inflation, which could force the Fed to keep monetary policy tight, even if it means a deep recession. In addition, there are a number of wild cards still in play this year—China’s reopening, war in Ukraine, energy strain in Europe, and messy global recession, to name a few—any of which could tip the world into crisis mode and lead the dollar to outperform again. As such, while dynamics working against USD this year will give investors yet another reason to diversify into other parts of the world, including international currency exposure, we see a strong possibility of intermittent dollar rallies as ongoing macro themes play out in 2023 and would not recommend a concentrated bet against.