The House Speaker Drama Will Hit the Market Next. Get Ready for the Debt Ceiling Battle

Even before the tussle erupted, Goldman Sachs economists called the debt limit the biggest political risk facing financial markets in 2023. Sometime in the summer or early fall, the Treasury’s legerdemain will give way to reality, and Congress will have to increase the nation’s borrowing capacity to pay for spending that it previously had authorized.'

Past fights over the debt limit have been couched as a crusade to force the government to spend within its means, like American households. A more apt metaphor: Failing to raise the debt ceiling is like refusing to pay credit card bills after spending on stuff.

In addition, “the MAGA crowd will use this issue to advance their anti-government crusade,” Greg Valliere, chief U.S. policy strategist at AGF Investments, writes in an email.

To be sure, the general notion of balancing budgets to curb the burgeoning national debt has widespread support. A survey commissioned by the Peterson Foundation finds that 90% of respondents want Congress to take a bipartisan approach to reducing the debt. One wonders who those other 10% are.

At the same time, concrete prescriptions for reducing the budget deficit—tax increases, radical spending cuts, major surgery for Medicare and Social Security—are deeply unpopular, Valliere notes.

Cutting the deficit will only become more nettlesome from here on. The trillion-dollar deficits that have become routine were no burden while interest rates were at their lowest in recorded history, and near zero in recent years.

That’s ending with the Federal Reserve’s normalization of monetary policy by raising its federal-funds rate over 4% and reducing its massive holdings of Treasury securities, accumulated to lower longer-term rates for the government and the private sector.

For the first time in 30 years, Congress is dealing with rising debt-servicing costs, the Strategas team notes in a report. As the weighted average cost of Treasury marketable debt rises above 2%, the federal government’s net interest cost is moving back up to over 10% of tax revenue. To be sure, that’s a far cry from the 19% of the early 1990s. But the expanding tab leaves less for other spending.

That’s the nerdy wonk take on the federal budget dilemma, which doesn’t play well on television. Better to rail against raising the ceiling on debt to pay for previous spending than to deal with the budget’s future trajectory. The Strategas team thinks some Republican members of the House won’t vote to raise the debt limit, even if it’s linked to spending cuts. And Democrats might be unwilling to go along with any cuts, they add. “Absent a major change, we are headed for a toxic debate this spring and summer as Congress is forced to raise the debt ceiling in a very divided and polarized political environment,” the analysts predict.

In the narrow, parochial terms of the stock market, the precedent of the vicious fight over the debt ceiling in the summer of 2011 coincided with a 10%-plus drop in the S&P 500 SPX +1.61% index. The fight culminated with Standard & Poor’s downgrading Uncle Sam’s credit by a notch, from the top AAA to AA-plus. “The downgrade reflects our view that the effectiveness, stability, and predictability of American policy-making and political institutions have weakened at a time of ongoing fiscal and economic challenge,” the rating agency said at the time.

It’s hard to argue that things have improved since then. Valliere opines that the hard right might even welcome a default to force radical spending cuts.

Ironically, the 2011 downgrade spurred a rally in Treasury prices and a drop in yields, in a typical flight-to-quality move by investors. Since then, other extraordinary schemes to stave off default have been floated, such as having the Treasury mint a $1 trillion coin, which would be accepted at the Fed, and in turn pay off debt obligations.

Such gimmicks would severely undermine U.S. government debt and the dollar as linchpins of the global financial system. The greenback’s status as the main currency for transactions, finance, and as a reserve already may be vulnerable, not only because of the nation’s huge $31 trillion debt, but also because other countries, seeking to avoid Washington’s influence, are looking for alternatives. That became more acute after sanctions were placed on Russia after it invaded Ukraine last year.

The House speaker fight is merely the preliminary bout. The main event will take place later this year, as Congress again gets ready to rumble. Or maybe bumble.