Trends: Will the debt ceiling unravel the Trump trade?

Scrapping the US debt ceiling will no doubt be absent from President Trump’s list of top priorities for his first 100 days in office, but it perhaps ought to be included. The US is due to hit its debt ceiling next month, after all, which falls well within President Trump’s first 100 days.

If the past two debt ceiling debates are anything to go by, the US will face a tough negotiation to suspend or raise the ceiling. And this at a time when President Trump is trying to push through a series of tax cuts and stimulus measures that are central to his platform.

The debt ceiling has for decades been a frustrating restraint on spending that has already been agreed and ratified. The brinkmanship involved in negotiating its increase has caused borrowing costs to rise and has led to the downgrade of the US. This was a problem for a government and markets already in austerity mode, but would pose an even greater challenge to the optimism that has underpinned the markets since President Trump’s election.

Proponents of the ceiling

The debt ceiling, as outgoing US treasury secretary Jack Lew pointed out in a recent piece, is “a broken, outdated system that no longer meets our country’s needs.” Indeed I recall attending the IMF meetings in Washington DC in 2013 and meeting with European policymakers who, after years of being told to get their fiscal houses in order by the US, channelled a huge degree of Schadenfreude at us as we watched US government buildings shut down over the debt ceiling.

The debt ceiling was implemented in 1917 in order to simplify the process of raising money in the US. Up until then, Congress had to meet and approve every single individual debt issuance by the government. This became increasingly onerous as the US had to raise money to finance its role in World War I.

Rather than have Congress meet regularly, the debt ceiling was implemented so that the government could borrow to finance spending that had already been agreed, but could not borrow uncontrollably.

The costs

The debt ceiling made more sense than forcing Congress to approve every debt issuance, but in recent years in particular has been hugely problematic. In both 2011 and 2013 when the US presidency was controlled by a Democrat but the House of Congress was dominated by Republicans, Congress engaged in brinkmanship over the debt ceiling and risked pushing the US into default.

The US has not defaulted on its debt obligations in well over 200 years. It has the most liquid, deepest asset class in the world in US Treasuries. As a result, the US benefits from being a safe haven and from having the world’s global currency. This keeps borrowing costs in US dollars low, and keeps US Treasury yields down.

As Lew has argued, the debt ceiling drama in 2011 and 2013 directly led to a downgrade of the US credit rating, a decline in stock prices, greater financial market volatility and widened credit spreads. Borrowing costs for the US government rose, as did those for US households and businesses.

Putting on the brakes for Trump?

It is difficult to find anyone who thinks hitting the debt ceiling is positive for the US economy. Should this be a major concern for President Trump, given that we are due to run into the next debt ceiling in March?

That will degree to a large degree on personalities and egos. Don’t forget, after all, that it was House Republicans who refused to raise the debt ceiling in 2011 and 2013 without spending cuts. President Trump campaigned on a platform of tax cuts and infrastructure and defence spending plans, all of which stand to raise the deficit and debt burdens.

If House Republicans stick to their ideology, then President Trump may face opposition when he tries to raise the debt ceiling this year. Republicans may have less of a problem spending money when it is one of their own allocating the funds as opposed to a Democrat though.

Still, many Republicans would claim that Trump is hardly one of their own; the President is not by most standards a traditional Republican. Nevertheless, budget hawks interested in their own political futures may decide to support the President when it comes time to raise the debt ceiling rather than sticking to their beliefs.

If budget hawks decide instead to stick to their guns, there will be a swift reaction in the markets. Ever since Mr Trump was elected, the markets have priced in an acceleration in growth and inflation as well as higher rates as a result of the new government’s proposed stimulus measures. If the government appeared to be careening towards the debt ceiling, the so-called “Trump trade” would likely unwind quickly.

A reversal of the Trump trade would be bad for the US, but hitting the debt ceiling could be negative for a number of other countries as well. According to a paper presented at the Jackson Hole Symposium in 2016, roughly 45 per cent of trade is invoiced in US dollars. Furthermore, around $10trn of foreign debt is denominated in US dollars.

The US dollar is the financing and trade currency of choice for a number of emerging market (EM) countries. If the US were to hit the debt ceiling and see its creditworthiness fall, it could spark a balance of payments crisis in EM that in turn could provide a real headwind for US growth.

Change is needed

President Trump has mooted a number of bold initiatives, which are almost universally expansionary. It is typical of politicians to promise policies first and worry about how to pay for them later, after they are elected. Racking up debt to finance Trump’s tax and spending initiatives is already likely to be difficult. But it might be brought into the spotlight swiftly in March when the government has to formally raise the debt ceiling.

Even if this government manages to agree to raise the ceiling swiftly, there could be controversy down the line, in another two years when the debt ceiling comes around again. Still, federal budget planning is not the kind of bold, attention-grabbing policy that Trump is likely to prioritise in his first 100 days at the helm of the government. It may not come to back to haunt him this time around, but that does not mean it never will.

Megan Greene is chief economist at Manulife Asset Management