The Complete Debt Ceiling Decision Tree: “An Alarmingly High Probability Of A Very Bad Outcome”
For all the breathless newsflow over the past 7 days, the single most consequential event of last week was the sudden jump in debt ceiling/government shutdown odds following Donald Trump’s confrontational Phoenix speech, which laid out a problematic dilemma: Trump’s Mexican wall, or a government shutdown. While various financial pundits rushed to discount the odds of a worst case scenario, the market – in Treasury bills, if not so much equities – was spooked, sending the “pre-post default bill” spread to the widest on record…
… as October 5/12 Bill yields continued to blow out after various politicians were quoted with doomsday predictions, some suggesting the odds of a shutdown are as high as 75%.
The biggest concern as we head into the X-Date period of late September, early October is that the resolution of these problems, either the debt ceiling or the government shutdown, is not a simple linear decision tree, but is one where any momentary whim, or tweet, by Donald Trump can abort any compromise at a moment’s notice. Or, as Deutsche Bank puts it in a Friday report looking at the Debt Ceiling Dynamics, “the current political backdrop is concerning” and as it adds, sarcastically, “a failure to raise the debt ceiling is a very bad outcome. And even a small probability of a very bad outcome is still a very bad outcome. Any kind of default would likely have far reaching negative ramifications for global financial markets and the US economy.“
Still, as discussed previously, while the T-Bill market is clearly paying attention, equities and VIX have yet to respond: as DB’s Dominic Konstam writes, “despite this tail risk and the apparent turbulence surrounding DC, markets remain comparatively unperturbed. Recent spikes in the VIX have proved short-lived although a little more elevated than before.” Still, there remains the risk of a sudden reaction as the deadline approaches if default risks become more tangible.
Just how likely is a “tangible risk” scenario? As DB calculates, there are several possible paths forward.
The most straight forward and positive for risk would be if leadership from both declared support for a clean raise. Where the path gets more complicated is if either party decides it will only support an increase if it is tied to a more partisan agenda item. Unfortunately we don’t see more than a 50/50 chance of even an attempt of a clean bill to raise the ceiling or suspend it. This is because the House Freedom Caucus (HFC) is on record against a clean bill. As early as May, Mark Meadows HFC Chairman said “at this point we believe that there need to be some structural reforms in any debt ceiling vote.”
While we disagree with Deutsche, and in light of the troubling dynamics between Trump and Congress, a 50% chance of a clean debt raise sounds ridiculously high, there are several other probabiltiies.
The tree diagram below gives Deutsche Bank’s “very subjective view” on the probabilities associated with how a debt ceiling debate may evolve. Here is the full breakdown:
We start with the 50/50 chance of an attempt at a clean versus dirty raise. If it is clean it very much depends whether the Democrats will support a clean bill as we assume the Republicans will not have the votes without the HFC. We suspect there is a good chance that they balk, but even if we assume this is only a 25 percent chance, conditional on a clean bill attempt, this leaves a good chance of a bill raising the debt ceiling (adds 37 ½ percent probability to a debt ceiling crisis being avoided).
As a knock on implication, this could also lead to a new era of moderate Republican and Democrat reconciliation, although not necessarily. If the Democrats do insist on conditions then the clean bill attempt ends in a no deal probability.
This takes us to the dirty scenarios.
The smallest probability (20 percent) is again with the Democrats insisting on conditions that are accepted leading to a deal that adds another 10 percent probability of a deal.
The rest of the probability goes to either a deal with the HFC or a failure to come together. The latter obviously is no deal whereas the former should lead to a deal which may or may not include Trump’s wall.
In total, Konstam estimates that the probability of no deal – or a technical default of the United States – is a whopping 33%. As the biggest German bank redundantly notes, “We think this is an alarmingly high probability of a very bad outcome.“
We conclude with some troubling parting words from Deutsche Bank:
Note that as in previous debt ceiling episodes there are possible fallbacks that would avoid default. There is the possibility of prioritization of payments, wherein Treasury would put principal and coupon payments on debt ahead of other payments, while still respecting the debt limit. Treasury Secretary Mnuchin told a House panel that he has “no intent on prioritizing,” but has not categorically ruled it out. Furthermore, while the Obama administration publicly maintained it was opposed to prioritizing the debt service, it came to light that Fed and Treasury officials had formalized a plan to do exactly that in 2011 if Congress and the White House hadn’t acted in time. There has also been in the past citation of the 14th Amendment, which, in Section 4, states “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.” This leaves open the possibility that the President might unilaterally decide to raise the debt ceiling by bypassing Congress and effectively declaring the debt ceiling unconstitutional. This was debated in both 2011 and 2013, with President Obama expressing concern about the damage resulting from such unilateral action, regardless of constitutionality.
That said, we doubt Trump would share Obama’s concerns about the optics of any executive-level action, “regardless of constitutionality.”