US Debt Ceiling and Treasury Bond Market: Understanding the Significance and Implications.

US Government Approaches Debt Ceiling, Risking Potential Default and Economic Consequences

What is the significance of the debt ceiling?

The debt ceiling is the limit on the amount of money the government can borrow to pay for services. The government takes in revenue from taxes and other streams but ultimately spends more than it takes in, leaving a deficit that gets tacked on to the country's total debt. To borrow money, the US treasury issues securities that it will eventually pay back with interest.

What happens when the US government hits the debt limit?

Once the US government hits its debt limit, the treasury cannot issue more securities, essentially stopping a key flow of money into the federal government. If the US defaults, investors would lose faith in the US dollar, causing the economy to weaken quickly. Job cuts would be imminent, and the US federal government would not have the means to continue all its services. The US has never defaulted on its payments before, so exactly what will happen is unclear. The US debt grows when the government is spending more money or when its revenue is lower.

Where does US spending go?

The biggest chunk of US government spending goes to mandatory programs, such as social security, Medicaid and Medicare, which comprise nearly half of the overall annual budget. Military spending takes up the biggest chunk of discretionary spending, taking up 12% of the budget. Other big-ticket items include spending on education, employment training and services and benefits for US veterans.

What is the historical context of the debt-ceiling situation in Congress?

The debt-ceiling farce being performed currently in Congress could turn from a mildly entertaining political show that has been played 79 times since 1960 into a truly hilarious financial show with a new ending where the debt ceiling isn't lifted, and where the US will then default on some of its obligations.

What is the current state of negotiations between Democrats and Republicans over the debt ceiling?

Given the stakes, Democrats have refused to negotiate spending cuts over the debt ceiling. Lawmakers including Alexandria Ocasio-Cortez have argued that Republicans should bring forth spending cuts during budget negotiations, not over the debt ceiling. Still, Republicans seem adamant on using the high-stakes timeline toward default to pressure Democrats into agreeing to spending cuts. They did this successfully in 2011, when Democrats agreed to spending cuts 72 hours before the government defaulted. On 26 April Republicans passed a bill in the House that would raise the debt ceiling by $1.5tn but mandated $4.8tn in spending cuts over a decade. A suspension of the debt ceiling until the next round of budget negotiations next winter is beginning to look increasingly likely.

What are the potential consequences if the debt ceiling is not raised?

President Joe Biden has warned that reneging on the country's national debt would be a calamity, exceeding anything that has ever happened financially in the United States. If the debt ceiling doesn't get raised quickly after the initial failure to raise it, eventually, the US government might not have enough cash on hand to be able to redeem a bond issue when it matures, and holders of these securities who thought they would get paid face value at the end of June might not get paid anything at the end of June, which would represent a maturity default, which would be very messy globally.

What does the market think of this situation?

The cost of insuring US government debt against default has been rising for weeks, with the spread on 5-year US credit default swaps jumping further to a decade high, nearly doubling from the beginning of the year. The 1-year US CDS derivatives, which act like insurance and pay out if a company or country defaults on its borrowings in the next 12 months, are trading at their highest level since at least 2008.

The rise in the CDS market underscores how investors are moving to protect against or profit from a default, even though it is still viewed as unlikely. Analysts said the market for one-year swaps was relatively small and illiquid, rendering it difficult to use as a gauge of market expectations of a US default.

How has the treasury bond market reacted?

The Treasury cash balance now sits at roughly $250bn, meaning that the X-date could come as soon as early June, significantly earlier than the previous estimate of between July and September. The Treasury bond market has experienced a significant drop in yields for securities with remaining maturities of around one month, with the one-month yield plunging 55 basis points to 3.40% at the close. Panic-buying frenzy was observed, resulting in prices of these securities jumping amid huge demand. The two-month yield, tracking Treasuries maturing in about two months, ticked up 1 basis point to 5.04%, with an increase of 25 basis points since March 31. The spread between the one-month yield and the two-month yield widened to an astounding 164 basis points, indicating that some people are panicking and piling into whatever they will be out of at face value in about one month.

What is the significance of this treasury yield spread?

The spread between the one-month yield and two-month yield could mean that investors are trying to protect themselves against a potential default. Investors are worried about the short-term outlook and are seeking securities that can be sold quickly if needed.

For more analysis on this topic, check out these articles:

1. US Debt Ceiling

   1. What is the US debt ceiling and what will happen if it is not raised?

   2. When will US hit its debt ceiling and what happens if country defaults?

   3. Danger and deja vu: what 2011 can tell us about the US debt ceiling crisis

   4. Short End of the Treasury Market Goes Totally Nuts. Doubts Creep in Over Debt Ceiling?

   5. Debt ceiling worries bubble up in US stock options market

   6. Cost of insuring against US default climbs on debt ceiling fears

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