Over the weekend, US President Joe Biden and House Speaker Kevin McCarthy finalized an agreement in principle to suspend the US debt ceiling through January 1, 2025. The deal is expected to be approved by Congress before June 5—the date Treasury Secretary Janet Yellen expects the United States to run out of cash. The agreement removes the possibility of an unprecedented default, provided it is signed into law, however it still modestly reduces expected government spending and will likely result in tighter near-term liquidity conditions. Taken together, the compromise slightly increases the risk of recession in the United States, which we already viewed as likely.
Markets reacted positively to the agreement, as spending cuts were seen as more modest than expected. For instance, the agreement limits expected increases in non-defense discretionary spending over the next two fiscal years by allowing a 0% increase in fiscal year 2024 and a 1% increase in fiscal year 2025. US Treasuries rallied, sending yields lower across most of the curve. The moves were most pronounced in short-term bills, where yields had increased in past weeks as the risk of default grew. US equities also opened higher in early trading on Tuesday, building on a strong rally last Friday amid growing optimism of a resolution being reached.
For more on this topic, please see Sean Duffin, “CA Answers: Should Investors Lean Into Quality Equities?,” Cambridge Associates LLC, March 31, 2023 and Celia Dallas and Sehr Dsani, “VantagePoint: Banking Crisis Implications for Asset Allocation,” Cambridge Associates LLC, April 2023.
Still, the Treasury will have to issue a large amount of debt in the next couple months to refill its coffers, which will drain liquidity from the financial system. The Treasury has run its cash balance down to just $39 billion to continue paying bills since the debt limit was reached in January, which is roughly $550 billion below its typical target. This has softened some of the impacts of the Federal Reserve’s quantitative tightening (QT) operations, but the anticipated debt issuance will pull liquidity out of the financial system, magnifying the impacts of QT. The Fed may respond by prematurely ending QT, which it did in late 2019 when strong Treasury issuance amid QT led to disruptions in the repo market. On balance, these dynamics will likely keep yields elevated in the near term. To add to this, futures markets are now pricing in another quarter-point rate hike by the Fed’s July policy meeting amid ongoing inflationary pressures.
While the debt ceiling agreement modestly increases the risks of a recession in the United States, we continue to recommend investors hold equity allocations in line with policy and tilt to quality-biased managers within their equity allocations.
Stuart Brown, Investment Director, Capital Markets Research
Vivian Gan, Associate Investment Director, Capital Markets Research