The need to increase the debt ceiling has emerged as the key issue when U.S. Treasury Secretary, Janet Yellen, surprised markets with the projection that the X-date (expiration) for Treasury funding may come as early as June 1st. The congressional deadlock now takes on new urgency with only 2 weeks for Washington D.C. to come to an agreement. Even though many Senators have publicly admitted that they have no plans to revisit the debt ceiling drama of 2011, we suspect the contentious rhetoric and politicking will be intense, and markets may not be able to ignore a conflict that is left unresolved until the “eleventh hour."

Although debt ceiling deadlines may feel somewhat like a déjà vu event, many political analysts feel this round of negotiations may be more difficult. The last memorable debate regarding the debt ceiling unfolded in 2011, which resulted in a credit rating downgrade of the U.S. Government to AA+ from AAA. This led to huge spikes in market volatility and large drawdowns in both equity and bond prices. The chart below shows the volatility indexes for equities (VIX Index) and bonds (MOVE Index) during that time period. Eventually, an agreement was achieved, and the volatility subsided.

Analysts at RBC Wealth Management do not see a realistic possibility of the U.S. defaulting on its obligations in 2023, but they also view that achieving a long-term solution by June 1st is also unlikely. Rather, a possible scenario is for a stopgap measure that extends the deadline until mid-June. Should that occur, the expected and timely influx of cash from corporate taxes could then push back the deadline for raising the ceiling until late July, providing a more realistic timeline for a final agreement. Should politicians continue to “kick-the-can” down the road, markets may not have the attention span to prioritize the negotiations as the top issue. Rather, the focus may return to Central bank policies, inflation, labour markets, and consumer spending data. We welcome this return to the fundamentals and would argue that this set of data is more relevant to the long-term recovery of the market.

The best-case scenario would be an early debt ceiling raise or suspension, accompanied by a fiscal adjustment or the establishment of a bipartisan commission on tax receipts and spending levels. In our view, any raise that occurs more than two weeks before the estimated deadline should be considered a positive outcome. However, this possibility is becoming increasingly difficult as political rhetoric intensifies.

More likely, is that the debt ceiling will be raised within two weeks of the X-date. It could even be more dramatic, with a settlement within days or even hours. This would rhyme with what was seen in 2011, with last-minute brinkmanship, hurried budget changes, and no real progress in the U.S. fiscal or political situation. It would not surprise us to even see the House reject a bill that is presented as the “last chance” to raise the ceiling. This could initially lead to a market sell-off, only to recover after a hasty and last-minute passage of the bill.

Even though the majority of investment and political pundits believe the debt ceiling will eventually be passed, the manner that it is passed also matters. When it comes to a world leader’s ability to pay their bills, there will be unintended consequences from political gamesmanship. Credit rating agencies will be pushed to reconsider the AAA rating of the U.S., which could lead to the forced selling of treasuries by some investors. The House may also need to elect a new Speaker in the process, which would cause an extended period of legislative inactivity. And at the minimum, a loss of global investor confidence driven by political dysfunction and uncertainty could justify a repricing in risk assets. Although repricing would not be permanent, it would not help a delicate stock market that has already dodged a few curve balls this year. Overall, we feel it would be reasonable to refrain from taking further equity risk for those who are already invested. However, for those who may have started the year offside and underexposed to equities, an opportunity may arise to build positions should a debt-ceiling-related pullback occur.