US: Shutdown Averted, Focus Turns to Debt Ceiling

• On Friday night Congress reached an agreement on the final part of the FY 2011 budget, which runs until end September this year, thereby averting a government shutdown.
• Focus now turns to the much more important discussion of raising the US federal debt ceiling, which the Treasury department estimates will be reached by 16 May.
• We expect the Congress to reach an agreement before the deadline, but the political discussions leading up to the agreement are likely to be intense.
• A risk premium is thus likely to be added to longer-term US yields during the negotiation process although the focus on tighter fiscal policy could work in the opposite direction.

Details

On Friday night Congress reached an agreement on the final part of the fiscal year (FY) 2011 budget, which will run until end September this year. The deal leaves spending USD79bn lower than the original FY2011 budget proposal from Obama and USD39bn lower than FY2010 spending for the remainder of the fiscal year.

Of the USD79bn reduction in the budget, calculations by the CBO estimate that actual outlays will only be reduced by approximately 60bn. This corresponds to 0.4% of GDP and hence the spending cut should have limited impact on growth. We estimate that the cut in government spending would push Q2 and Q3 GDP growth from our current estimated 4.1% q/q AR to around 3.8% q/q AR on average. However, the effect will be temporary since the cuts are only affecting programmes with annual appropriations and does not touch upon the major healthcare and pension entitlement programmes.

Focus now turns to the much more important discussion of raising the US debt level, which the Treasury department estimates will be reached by 16 May. According to Treasury Secretary Geithner, a failure to raise the debt ceiling would mean that the US has "no headroom to borrow within the limit after about July 8, 2011". The consequence would be that the US effectively defaults on its debt, which would add a significant risk premium to US government bond yields, cause severe financial problems and have major negative economic consequences as it would mean suspension of key government services including Social Security and Medicare benefits.

The debt ceiling currently stands at USD14,294bn and US federal debt was by March 31 USD76bn below the ceiling. According to a CRS1 report from February, the federal government will have to issue an additional USD783bn in debt above the current debt limit to finance its obligations for the remainder of FY2011.This corresponds to slightly more than 20% of the total outlays for the entire FY2011. Hence, there is no reasonable way that the government can manage to stay below the debt ceiling by cutting spending (see also the report by the Congressional Research Service from February).

Assessment and outlook

Some Republicans have already indicated that they want further spending cuts in order to vote for raising the debt ceiling and the risk is that the debate over the coming weeks could send the risk premium on US government bonds higher. Historically however, Congress has always raised the debt limit before the government ran out of cash and was unable to pay its obligations. We believe this will be the case once again but the coming weeks could show an high-level political game of chicken.