While the US defaulting on its debt remains a very unlikely scenario, concessions on fiscal policy made as part of debt-ceiling deals, as well as market volatility around the so-called ‘x date’, mean debt-ceiling negotiations are a key political event for investors to watch going forward.

Latest debt-ceiling talks – a familiar and risky path

The likelihood of political conflict over raising the US debt ceiling this year was always high given the current structure of Congress.

The most contentious debt-ceiling negotiations typically occur when the White House and the Senate are controlled by Democrats, while the Republicans control the lower House of Representatives (as is currently the case).

This political dynamic requires an element of bipartisan compromise to reach any agreement, but typically results in Republicans seeking greater spending concessions than Democrats are willing to give, resulting in drawn out negotiations.

What’s more, voting patterns show that political polarisation has increased (see Chart 1), making bipartisan agreement harder to achieve – posing greater debt-ceiling risks. This will hamper future negotiations.

Source: Vote view, DW-NOMINATE, abrdn, March 2023. Note: Liberal-conservative ideological score in which -0.6 is the most liberal and 0.6 is the most conservative.

Short-term, long-term implications

As with previous tough debt ceiling negotiations, a deal was only approved by Congress at the last minute on June 2, just days before June 5 – the point at which the government would have exhausted its cash balances and could not borrow any more money.

The last-minute nature of debt-ceiling agreements contribute to the market stress we tend to see in the run up to a deal being reached (see Chart 2). While this volatility tends to disappear quickly, there can be long-lasting effects from close run debt- ceiling negotiations.

For example, the 2011 debt-ceiling crisis resulted in a downgrade to the US’ credit rating. Earlier this year, the debt ceiling was cited as the factor behind ratings agency Fitch’s decision to put the US on negative watch, indicating they were considering a downgrade.

These developments can lead to volatility in the stock market, as well as an increase to the costs of insuring US government debt.

What’s been agreed?

The deal that was struck between President Joe Biden and Republicans means cuts to government spending over the next two years, while suspending the debt-ceiling review until January 2025. Non-defence spending will be held mostly flat relative to 2023 in 2024, with budgets increasing by 1% in 2025.

Given the pace of inflation, this amounts to a modest cut to government spending, but less than the 9.2% reduction Republicans had originally sought.

Relative to planned spending increases, the agreement roughly amounts to less spending equivalent to some 0.2%-0.3% of gross domestic product (GDP). Republican plans would have equated to a drag of around 0.5 percentage points on GDP growth in 2024, with further hits in subsequent fiscal years.

The biggest impact of the deal is likely to be that the government will be unable to introduce large spending programmes to support the economy in the event the US slips into recession.

With President Biden’s hands tied by the spending caps, the US government will be left relying on existing policies to address any increase in unemployment an economic downturn may cause.

Political risks in the US persist

Even though the risks of the US defaulting on its debt have receded since the deal was passed and signed into law, there continue to be repercussions.

A small group of Republicans unhappy with the agreement have blocked all legislation from progressing in the House – resulting in political gridlock. They are seeking significantly greater spending cuts than those agreed.

This sets up the 2024 budget negotiations process as the next high-stakes moment in US politics, with potentially significant implications for businesses exposed to US government funding, as well as those receiving social security payments.

If the 2024 budget is not agreed by September 31, a government shutdown is possible. Under the terms of the debt-ceiling agreement, failure to reach an agreement on the 2024 budget will result in a blanket 1% cut to all budgets, which would further reduce the government’s ability to introduce new spending measures ahead of the 2024 election.

Investors must be mindful of US politics

The recent debt ceiling clash is only one example of the ways in which politics in the US can have market implications.

With the government budget negotiation process yet to begin and the 2024 US presidential election beginning to appear over the horizon, policy volatility and uncertainty over the direction of travel may weigh on markets.

This trend shows little signs of abating any time soon, making domestic politics in the US a key area to watch going forwards.