We recently reached the ceiling of the limit of the State debt in the US. This notion of a ceiling happens regularly since it has already happened several times in the past. But what does that imply? Does this represent a risk for cryptos? This is where we will look at the subject together.
What does the debt ceiling mean?
First, it is better to define the principle of the debt ceiling. To make it simple, the cap is the limit over which the state (federal government) is allowed to borrow. This is in order to ensure its financial responsibilities. We know that the economy is quite dependent on debt, and all the more so when we know that expenditure is greater than income, budget deficit.
The last limit had been set at 31.4T and it was reached on January 19, 2023.
The debate between Republicans and Democrats
The subject is very often debated between Democrats and Republicans for the simple reason that they do not agree on the subject. The Republicans would like to favor a reduction in spending and not an increase in the ceiling, while the Democrats want the opposite. Moreover, increasing the limit would simply be to pay one’s financial obligations and avoid default. The subject was already debated in August 2021, and the ceiling had been increased by 1.7T under the presidency of Joe Biden. However, since January 2023, the House is once again controlled by Republicans while Democrats control the Senate and the Presidency. Therefore, we should see a debate similar to 2011.
A date for the final decision?
We know that the debt ceiling was reached on January 19. Even if it is difficult to define precisely when they will meet to discuss and find a solution, we know that it should be by June. Moreover, it is not the best year to have this kind of event added to the landscape 2023. Economic growth is already weakened by the rise in rates in 2022, inflation remains high and rates are going to be maintained at a certain level. This is a risk to consider.
State funding sources
If the US were to enter a recession, this should pressure more quickly since the debt ceiling has already been reached. The taxes are not sufficient enough to finance the expenses, and the deficit quite large. Therefore, one needs to issue government bonds to finance expenditures.
Part of a recession often involves increasing the country’s debt level. This can be seen in the table below.
If the USA goes into recession and no decision is made, we will have to speed up the debate process. This is in order to avoid more serious consequences on the economy and the financial markets. And even more so if the debate is much too late. In the worst case, the result would be not to increase the limit in times of crisis.
Default risk
We know that in 2011, the debate and the crisis around the debt limit were already present. Moreover, the company Standard & Poor had lowered the note given to the bonds of states so appreciated by the public. During this period of uncertainty, there have been strong ups and downs in the financial markets. Uncertainty increases fear, and therefore creates more volatility. This can be seen precisely via the VIX (fear index) during this period.
Currently, it is known that increasing the limit serves mainly to pay one’s financial obligations. Therefore, not increasing the ceiling increases the risk of default. A default risk would be really disastrous for the economy knowing that the level of growth remains weak for 2023.
The risk compared to cryptos
Both cryptos and more risk-sensitive assets can react strongly to default risk in the US. A risk of default could heighten fears of a severe recession, job loss and a crypto crash. For what? Uncertainties around this could cause panic selling and liquidation among investors.
On the other hand, the level of investment and asset allocation in the US is very high. Consequently, a slowdown in growth combined with a risk of default could impact all asset classes.
The risk compared to US bonds and equities
The bond market is the biggest market, much bigger than the stock market in the US. It takes up a lot of space, especially in pension funds. Bonds are considered safer products. Admittedly, the bond market has already been greatly affected in 2022 due to the rapid rise in rates and QT. But it was quite resilient since the Central Bank did not need to intervene for liquidity risk. This was also the case in the United Kingdom, for example.
On the other hand, investors will want to obtain higher rates to be compensated for the greater risk of the situation. Consequently, this will also affect equities since companies will be indirectly impacted. For what ? Higher rates to offset the risk can put pressure on companies since the financing rate would be higher.
The uncertainty surrounding the debate between Republicans and Democrats could weaken the US dollar. In times of uncertainty and risk of default in the US, investors may want to sell the US dollar. This in order to invest abroad since the country will be seen as a riskier bet.
The impact of the FED’s NET liquidity
While waiting for everything to be put in place, particularly around the debate, the State uses the liquidity available in the TGA treasury account. We can see on the graph below a decline for a few months since the liquidity has been released for treasury operations.
This situation also made it possible to offset the effect of the Fed’s monetary tightening program, namely QT (quantitative tightening). This program in place since June 2022 to contract liquidity in the financial system has not really had a greater impact. The effect was counterbalanced thanks to the liquidity of the TGA (treasury account). We can precisely see that the Fed’s net liquidity has stabilized for several months.
However, when the government again bails out the treasury account through bond issues, it will create some liquidity hole. Especially if the Fed’s QT (restrictive program) is still in place.
The central bank (the FED) to the rescue?
We know that the major role of a central bank remains the stability and security of the financial system. Therefore, it would be logical for it to come to the rescue to avoid much more serious consequences. The central bank could actually use its own tools to help.
As the situation was similar in 2011, especially concerning the disagreement of the Democratic / Republican debate on the debt ceiling. There had already been talk of discussing the measures to be put in place, particularly in a transcript at the time. There had been talk that it could buy back the bonds in default provided that they suffered a political impasse. On the other hand, there was no question of buying back the bonds if the impasse came from an incapacity of the country itself.
Conclusion
One way or another, there is a high probability that the ceiling will be pushed back again. If this is not the case, there is a strong probability that the FED will intervene in order to ensure a certain stability of the system. These uncertainties are likely to cause more volatility in the coming months since we face both weak growth and a risk of default. Therefore, cryptos are not immune to this possible risk.
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