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One deadline down, but another remains

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      By Andrew H. Friedman, Principal, The Washington Update and Jeffrey B. Bush, The Washington Update

      Washington - Since the beginning of 2018, the government funding imbroglio has consumed Washington. With a second government shutdown looming, the two parties finally compromised on legislation funding the government through September, an eon away by congressional standards.

      While the government funding debate is over, a more troublesome deadline awaits. Congress has authorized the federal government to borrow additional funds only through March 2. If Congress does not extend that authorization (raise the "debt limit"), then beginning March 3 the government will be unable to borrow more funds. The federal government can limp along without additional borrowing for about six months using current tax receipts and funds set aside for future expenditures. But, by early next fall (if not before), the government will need to borrow more. (The precise date depends on the actual revenues received and expenses incurred.) If Congress fails to increase the debt limit by that time, the United States, unable to borrow, will be unable to pay interest on its debt outstanding, potentially leading to default on the entire national debt.

      One thing remains clear to us: Congress will not allow the United States government to default on its debt. If, however, the parties engage in a game of "chicken" as the deadline approaches, the uncertainty could have a profound effect on the markets.

      Indeed, some observers already are raising this concern. Last month, Fitch Ratings warned that Congress's failure to address the debt limit in a timely fashion could do lasting damage to the country's credit and cause Fitch to begin to reconsider the country's Triple-A rating.

      The U.S. faced a similar showdown over the debt ceiling in 2011. Criticizing the lack of a "credible plan" to manage the upward trajectory of the national debt, S&P at that time lowered the U.S. credit rating from AAA to AA+, a rating that persists today.

      The S&P downgrade led to a global sell-off in equities and (paradoxically) a flight to US Treasuries, lowering interest rates. A downgrade by Fitch, or a congressional failure to address the debt ceiling until close to the deadline, could produce a similar sell-off. Alternatively, some observers are suggesting a downgrade this time could reverse the flow away from Treasuries. They reason that the government must sell much more debt now to fund a $1 trillion-plus annual deficit. In 2011, the Fed and foreign purchasers absorbed the bulk of the Treasuries sold. Now those purchasers are buying much less. The remaining purchasers could demand higher interest rates to be willing to absorb the burgeoning supply. Thus, a failure to address the debt ceiling could result in an equity sell-off or a jump in interest rates (or both), a "pick your poison" scenario.

      Adding to the uncertainty is the fact that government funding also will run out in September. Congress is likely to consider appropriations and debt limit legislation as a single package. Melding two such contentious issues makes a timely compromise even more difficult.

      Bottom line: Given Congress's contentiousness, there is no reason to believe that we will see an early compromise to raise the debt limit. If that failure prompts a downgrade of the nation's credit, or worldwide concern about the fate of the nation's outstanding debt (or both), the markets could react negatively. Investors should keep an eye on the rhetoric emerging from Washington over the summer to gauge whether Congress is likely to let these issues linger, perhaps foretelling an adverse market reaction.