Debt Ceiling

Published on February 2017 | Categories: Documents | Downloads: 55 | Comments: 0 | Views: 288
of 10
Download PDF   Embed   Report

Comments

Content

Federal Deficits and Debt
neuberger berman FixeD i nCome te am

Much has been written lately regarding the size and sustainability of the United States’ Federal debt and how it relates to economic growth in the coming years. At the time of writing, President Obama and the U.S. Congress are engaged in negotiations to find a solution to the issue; however, the budget deficit and indebtedness are likely to remain crucial issues for the economy and the markets over the long term. In this paper, we analyze the current situation and its potential implications. D e b t C e i l i n g l i m i t a n D a s s o C i at e D i s s u e s

One immediate challenge facing the United States is the impending debt ceiling limit, which may impact scheduled interest payments, limit upcoming issuance and potentially cause the federal debt of the U.S. and its Agencies (Fannie Mae, Freddie Mac, Federal Home Loan Bank, Federal Farm Credit Bank) to be downgraded. A short-term technical default (in which the bondholder is not paid on the anticipated day but expects to be paid in the near future) or a downgrade of the U.S. sovereign debt rating may not have many real, long-lasting economic consequences as the willingness and ability of the government to honor its obligations may not come into question. However, a protracted technical default would create such uncertainty and could lead to political and economic chaos. In our view, this would affect all asset classes, as well as fundamentally change the stability of the financial system. However, we believe the probability of this outcome is de minimis as it appears that the various actors in what has become a political drama understand the serious ramifications such an outcome entails.

83

31

72

Indeed, given all the risks for potential destabilizing economic and political chaos at a time when the economy is not yet on a fully sustainable organic growth path, one probable outcome is an agreement involving both political parties to modestly extend the debt ceiling in exchange for a future reduction in the deficit. This “solution” allows more time to address the fundamental spending and taxation issues. The table below describes some potential outcomes and their implications.
Figure 1: market impliCations For Various asset Classes*

85 100 30 67 100 48 100 100 55 55 100 100 83

31 72

90 100 3

C M Y K

60 30 0 30

U.S. Government
Short-term fix to the debt ceiling / deficit Long-term fix to the debt ceiling / deficit Downgrade to U.S. debt obligations Steeper yield curve and potentially higher interest rates Flatter yield curve and potentially lower interest rates Steeper yield curve with higher long rates

Credit
Higher risk premiums Lower risk premiums Financials underperform

Equities
Higher risk premiums Lower risk premiums Uncertain but potentially higher risk premiums

*This table is intended to illustrate how certain asset classes may generally respond to various potential short-term and long-term scenarios regarding the debt ceiling limit and the deficit. The conclusions are representative only of the authors’ opinions based upon their view of the key characteristics of the various asset classes; actual effects on any of the asset classes and actual results of any investments may vary materially. This table should not be relied upon to make any investment decision and does not constitute investment advice.

1

FeDeral DeFiCits anD Debt

long-term struCtural problem

According to the U.S. Office of Management and Budget, the projected 2011 federal budget deficit will be $1.645 trillion or 10.9% of GDP. This most recent deterioration of the fiscal picture has resulted from an increase in spending in an attempt to soften the impact of the financial crisis on the U.S. economy. The dynamics are unmistakable. Spending has risen to post-World War II highs while receipts have declined to the lowest level since the early 50s.
Figure 2: FeDeral outlays HaVe outstrippeD reCeipts % of GDP
50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 1941 1951 1961 1971 1981 1991 2001
23.8%

Outlays Receipts

14.9%

2011E

Source: U.S. Office of Management and Budget. Data for 2011 is estimated.

Figure 2 exhibits the problem as it has evolved over the last several decades going back to the late 70s. The situation has obviously become much more acute since the financial crisis as spending and receipts have diverged significantly. Federal receipts averaged 18.3% of GDP from 1980 through 2007 but have since declined to 15.4% of GDP on average since then. Additionally, over that same timeframe, individual income taxes went from an average of 8.4% to 6.9% of GDP while corporate taxes went from 1.9% to 1.5% of GDP. A contributing factor to the weakness in revenues is the fact that capital gains revenues were particularly strong in the late 1990s but have been much weaker in the past several years.
Figure 3: reVenues HaVe sloweD witH eConomiC weakness % of GDP
30% 28% 26% 24% 22% 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 1971 Individual Income Taxes Corporate Income Taxes Social Insurance (Payroll) Taxes Other Revenues

1976

1981

1986

1991

1996

2001

2006

2011E

Source: U.S. Office of Management and Budget. Data for 2011 is estimated.

2

FeDeral DeFiCits anD Debt

Looking again at outlays, they averaged 20.8% of GDP from 1980 to 2007 but have increased to 23.7% of GDP since 2008 and are projected by the U.S. Office of Management and Budget to reach 25.3% of GDP for fiscal year 2011 due to the variety of stimulus and support programs designed to help sustain the U.S. economy (see Figure 2). The largest single expenditure in 2010 was Social Security, followed by National Defense and Medicare, while the interest on the national debt was 5.7% of GDP (see Figure 4). Overall, these figures translate into average budget deficits of 2.6% for 1980-2007 and average deficits of 8.3% since then.
Figure 4: soCial seCurity, national DeFense anD meDiCare are key Cost areas 2010 Federal Spending ($ Millions)
Interest 5.7% $196,194 Everything Else 31.2% $1,077,350

Health Care Services 9.6% $330,710

Medicare 13.1% $451,636

National Defense 20.1% $693,586

Social Security 20.4% $706,737

Source: U.S. Office of Management and Budget.

The following two tables highlight the drop across the main sources of government revenue by $405 billion since 2007. At the same time, spending has increased by $727 billion and has been concentrated in human resources (health care, Medicare, income security, etc.)
Figure 5a : FurtHer Details on FeDeral reVenues anD outlays
Receipts by Source: 2007 vs. 2010 (In Millions of Dollars) SoCIal InSURanCE anD REtIREMEnt RECEIptS Fiscal Year 2007 2010 $ Change % Change Individual Income taxes 1,163,472 898,549 -264,923 -22.8% Corporate Income taxes 370,243 191,437 -178,806 -48.3% total 869,607 864,814 -4,793 -0.6% (on-Budget) 234,518 233,127 -1,391 -0.6% (off-Budget) 635,089 631,687 -3,402 -0.5% Excise taxes 65,069 66,909 1,840 2.8% other 99,594 141,015 41,421 41.6% total 2,567,985 2,162,724 -405,261 -15.8% total RECEIptS (on-Budget) 1,932,896 1,531,037 -401,859 -20.8% (off-Budget) 635,089 631,687 -3,402 -0.5%

Source: U.S. Office of Management and Budget.

3

FeDeral DeFiCits anD Debt

Figure 5b : FurtHer Details on FeDeral reVenues anD outlays
outlays by Superfunction and Function (In Millions of Dollars) SUpERFUnCtIon anD FUnCtIon national Defense Human resources Education, Training, Employment, and Social Services Health Medicare Income Security Social Security (On-budget) (Off-budget) Veterans Benefits and Services physical resources (energy, transportation, Development, etc.) net interest (On-budget) (Off-budget) other functions (int'l affairs, ag, Justice, gen gov't) undistributed offsetting receipts total, Federal outlays (On-budget) (Off-budget) 2007 551,271 1,758,391 91,656 266,382 375,407 365,975 586,153 19,307 566,846 72,818 133,815 237,109 343,112 -106,003 130,338 -82,238 2,728,686 2,275,049 453,637 2010 693,586 2,385,731 127,710 369,054 451,636 622,210 706,737 23,317 683,420 108,384 88,753 196,194 314,696 -118,502 174,065 -82,116 3,456,213 2,901,531 554,682 $ ChanGE 142,315 627,340 36,054 102,672 76,229 256,235 120,584 4,010 116,574 35,566 -45,062 -40,915 -28,416 -12,499 43,727 122 727,527 626,482 101,045 % ChanGE 25.8% 35.7% 39.3% 38.5% 20.3% 70.0% 20.6% 20.8% 20.6% 48.8% -33.7% -17.3% -8.3% 11.8% 33.5% -0.1% 26.7% 27.5% 22.3%

Source: U.S. Office of Management and Budget.

Overall, the gross amount of federal debt outstanding has grown from 57.3% of GDP in 2000 to 93.2% in 2010. The main change regarding the holders of federal government debt over this time has been the steady increase in the amount of intra-governmental debt (or the debt owed among government agencies) since the 1980s, which is largely due to the surplus revenues from Social Security taxes that, by law, have to be invested in U.S. Treasuries.
Figure 6: Debt burDen Has grown relatiVe to eConomy Gross Debt as % of GDP
130% 120% 110% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Intra-Govt Fed Reserve Other Total

93.2%

56.6%

31.1% 5.6%

1941

1951

1961

1971

1981

1991

2001

2011E

Source: U.S. Office of Management and Budget. Data for 2011 is estimated.

4

FeDeral DeFiCits anD Debt

Early in the decade, most issuance was of Treasury bills, which drove down the average maturity of the federal government’s marketable debt. However, the composition has since shifted to 2 – 10 year notes, which has in turn increased the debt’s average maturity to levels not seen in close to a decade.
Figure 7: aVerage maturity oF FeDeral Debt Has been rising
75 70 65 Months 60 55 50 45 40 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Source: U.S. Treasury. Data through June 30, 2011.
62 Months

Average Maturity of Marketable Debt

Debt limit CoulD exCeeD key tHresHolD

According to the U.S. Treasury Department, “The debt limit is the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments.” One theory regarding the importance of an increase in the debt limit centers on the fact that it would take the U.S. to above the psychologically important 100% of GDP. Research by Carmen Reinhart and Kenneth Rogoff 1 (and reiterated in their article on Bloomberg on July 14, 2011), suggests that, at the 90% debt-to-GDP level, the stresses on an economy become so severe that they result in serious negative effects on growth. Even given currently low interest rates and the potential to issue low-cost debt, the two authors believe that it would “be folly to take comfort in today’s low borrowing costs, much less to interpret them as an ‘all clear’ signal for a further explosion of debt.” 2 At these levels, an economy becomes more reliant on the acquiescence of the markets to fund and roll over existing debt. That’s not a current issue, but over the long run could become more of an uncertainty. Also, if the economy does fall back into recession (not what we expect), the federal government would be severely limited in the amount of additional support it could provide due to borrowing limitations.

1 2

Reinhart, Carmen M. and Rogoff, Kenneth S., This Time Is Different: Eight Centuries of Financial Folly, Princeton University Press, 2009. “Too Much Debt Means the Economy Can’t Grow: Reinhart and Rogoff,” Bloomberg, July 14, 2011.

5

FeDeral DeFiCits anD Debt

Figure 8 : running out oF room on Debt
16,000 15,000 14,000 $ Millions 13,000 12,000 11,000 10,000 9,000
68% 69% 78% 73% 86% 87%

Debt Subject to Limit ($ Millions) Increases in Debt Limit (% of GDP)
99%

?

8,000 Jan-07

Jun-07

Jan-08

Jun-08

Jan-09

Jun-09

Jan-10

Jun-10

Jan-11

Jun-11

Source: Treasury Direct. Data through June 30, 2011.

stop-gap measures —anD a looming DeaDline

Given the lack of progress in increasing the debt limit, the U.S. Treasury took actions on May 16, 2011 to free up space under the debt ceiling, which mainly involved intra-governmental debt. Even with these measures, the Treasury projects that the U.S. will exhaust its authority to continue to borrow on Tuesday, August 2. Some in the media and markets have questioned whether there is an actual Constitutional need to increase the limit (mostly based on interpretations of the 14th Amendment to the U.S. Constitution). However, this appears to be a “long shot” interpretation which could result in legal challenges that could add more uncertainty and potentially increase risk premiums across markets at a very bad time. The uncertainty has caused both Standard & Poor’s and Moody’s to issue statements regarding what may happen if the debt ceiling is not raised and if there is a technical default, including placing the U.S. credit rating under review.

6

FeDeral DeFiCits anD Debt

Summary: Rating Agency Statements april 18: • S&P reiterates its negative outlook, representing the next six to 24 months, and assigning a one-in-three chance of a ratings action during this timeframe. • S&P cites the need for fiscal consolidation as the main factor for its decision. • S&P later clarifies that a failure to make any debt payments (such as for T-bills maturing August 4, would constitute an immediate default and would rate these securities as D (defaulted). • S&P also notes that failure to make scheduled entitlement payments could also cause ratings action. July 12: • Moody’s places the U.S. credit rating on “ratings under review” status “prompted by the possibility that the debt limit will not be raised in time to prevent a missed payment of interest or principal on outstanding bonds and notes.” • Moody’s sees “a small but rising risk of a short-lived default” but indicates that if the debt limit is raised, Moody’s would affirm the current AAA rating. • In the case of a default, Moody’s would reduce the U.S. credit rating “somewhere in the AA range” and would likely keep that rating even after the situation was resolved. July 14: • S&P announces that the credit rating of U.S. sovereign debt had changed from “outlook negative” to “creditwatch negative.” • This implies a change in the likelihood of an S&P downgrades from one-in-three over the next two years to one-in-two over the next 90 days, “owing to the dynamics of the political debate on the debt ceiling.” • S&P is looking for a medium-term fiscal consolidation plan of roughly $4 trillion to affirm the AAA rating.

It should be noted that, in the opinion of many observers, a technical default would not raise any question of the country’s ability or willingness to pay; rather, it would reflect a legal and/or political situation in which the Treasury could not make payments. Some market participants believe this difference is the reason that rates have not risen dramatically in the run-up to the debt ceiling limit, but in our opinion the event of a technical default would likely result in some increase in rates (especially on the long end) and cause a steeper yield curve.

7

FeDeral DeFiCits anD Debt

t e C H n i C a l D e Fa u lt s C e n a r i o s

The Treasury has been adamant that, on August 2, it will run out of cash; however, given their cash on hand and tax receipts running approximately 10% ahead of 2010 levels, we think that August 2 is not the “drop-dead” date that is being portrayed. The following are key dates in August:
• 1st: Scheduled Social Security and Medicare Payments • 1st: Interest Payment Due • 2nd: Treasury Deadline • 3rd: Scheduled Auction Announcements • 4th: Treasury Bill Auction/Maturity • 9th: Scheduled 3-Year Auction • 10th: Scheduled 10-Year Auction • 11th: Scheduled 30-Year Auction • 11th: Treasury Bill Auction/Maturity • 15th: Scheduled Refunding Settlement • 15th: Interest Payment Due • 18th: Treasury Bill Auction/Maturity • 25th: Treasury Bill Auction/Maturity • 31st: Interest Payment Due

In the scenario that August 2 is indeed a “drop-dead” date and there is no leftover cash on hand, it is possible that the Treasury would delay its auctions to ensure that settlement would be guaranteed. Since 1995, the Treasury has delayed announcements for auctions 17 times (for two-year auctions in 2002, 2003 and 2004, and for three-year and 10-year auctions in 1995) and has delayed actual auctions 11 times, with the longest delay being eight days. In this case, a technical default would result in delayed payments of bond interest and principal. This would be the fourth instance of a technical default in the history of the U.S. The first was during the American Revolution, when debt was not serviced but was ultimately “made good” in the 1790s. The second was 1933 when Congress eliminated the gold-based obligations clause of its debt to domestic investors and instead made payment in “fiat dollars.” The third occurred in 1979, when, during debates over the debt ceiling, some payment glitches at the Treasury caused delayed payments on some T-bills. In the event that the debt ceiling is not increased and assuming the government uses its cash on hand to make payments, the Treasury would most likely have to prioritize the various payments starting on August 2. Without using its cash balance (currently around $74 billion), the Treasury would not be able to fund the anticipated $27 billion to $32 billion in upcoming payments for Social Security ($22 billion) and other areas ($5 billion to $10 billion) such as Medicare, defense contractors, federal employees and state governments. However, with some flexibility in the payments it may choose to make, the Treasury could seek to prolong the period before the debt threshold is reached.

8

FeDeral DeFiCits anD Debt

e C o n o m i C a n D p o l i t i C a l r a m i F i C at i o n s

Ultimately, this is a political issue and one that needs to have a long-term solution. In our view, the divergence of revenues and outlays is the first problem that needs to be addressed. Unfortunately, the situation is quite daunting. Revenue increases could likely involve an increase in tax rates or the number of people paying taxes. However, we believe that neither of these choices is likely to be effective in the near term as increasing rates could slow the current, already anemic recovery and ongoing high unemployment would make it challenging to increase the tax rolls.
Figure 9: subpar reCoVery makes reVenue solutions DiFFiCult The current recovery has been one of the weakest since World War II, especially considering the severity of the recession.
Recession
1948 – 49 1953 – 54 1957 – 58 1960 1970 1973 – 75 1980 1982 1991 2001 2007– 09 average

Decline in GDp (previous peak to trough)
-1.7% -2.6% -3.0% -1.6% -0.6% -1.6% -2.2% -2.7% -1.4% -0.3% -5.1% -2.1%

Increase in GDp (2 Years after trough)
16.9% 9.6% 13.0% 10.6% 6.3% 6.9% 1.6% 12.9% 6.1% 3.1% 5.0% 8.4%

Sources: Bloomberg and Neuberger Berman. Data through June 30, 2011.

Another way to enhance revenue is to reform the tax code to increase efficiency and grow revenues, but given the current political environment, this seems to be more of a long-term project that would perhaps be tackled after the 2012 presidential elections. On the expenditures side, it appears that near-term fiscal consolidation is in the cards but its scale remains in question. Assuming no extension in programs such as extended unemployment benefits and payroll tax holidays, the reduction in transfer payments to individuals would not only decrease government expenditures but would have the “second order” effect of decreasing personal incomes — which would, in turn, lower personal consumption expenditures. Over the long run, we believe entitlement reform will be addressed. The run-up in intragovernmental debt since the mid-1980s essentially amounts to the use of revenues from the Social Security Trust Fund to fund current government spending. With a reform of entitlements and a slowing in the currently steady growth of this aspect of the federal debt, there would be an immediate impact on total debt, giving the government more space under any debt ceiling.

9

FeDeral DeFiCits anD Debt

s H o r t- t e r m o u t l o o k a n D C o n C l u s i o n

Beyond the immediate political conflict, there are a number of reasons why the issue of debt has such resonance and carries so many challenges today. The ratio of U.S. gross debt to GDP is approaching 100%, which reduces the government’s flexibility going forward; the evolving European sovereign debt crisis is highlighting the problems associated with excess debt and slow growth; and, finally, increased borrowing costs compared to nominal economic growth could have a detrimental impact on capital markets around the world as risk premiums increase and market participants become more risk-averse. In our view, failed spending and tax policies and unfavorable demographic changes, combined with an adverse debt-growth mix, have created a situation that is unsustainable — a sentiment that many others share. Many observers believe that a short-term technical default and the accompanying downgrade in the U.S. sovereign debt rating may not have many real, long-lasting economic consequences as the willingness and ability of the government to pay is not in question. However, a larger event, such as a longer delay in the payment of interest, could trigger further political and economic turmoil because it would bring into question the willingness of the government to pay its debts. In our view, this would affect all asset classes and could fundamentally change the stability of the financial system. The probability of this outcome, in our view, is de minimis, and something that even the most fervent deficit hawks want to avoid. Given all the risks for potential negative outcomes at a time when the economy is not yet on a fully sustainable organic growth path, we think it is likely that both parties will agree to modestly increase the debt ceiling and potentially offset the amount with spending cuts in order to gain more time to address more fundamental issues, including entitlements.

Partnering With Clients For Over 70 Years

This material is presented solely for informational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. No part of this document may be reproduced in any manner without the written permission of Neuberger Berman Fixed Income LLC. past performance is no guarantee of future results. This document is issued by Neuberger Berman Europe Limited which is authorised and regulated by the UK Financial Services Authority (“FSA”) and is registered in England and Wales, Lansdowne House, 57 Berkeley Square, London, W1J 6ER. Neuberger Berman is a registered trademark. Neuberger Berman Fixed Income LLC is a Registered Investment Advisor. L0216 07/11 ©2011 Neuberger Berman Fixed Income LLC. All rights reserved.

Neuberger Berman LLC 605 Third Avenue New York, NY 10158 www.nb.com

10

Sponsor Documents

Or use your account on DocShare.tips

Hide

Forgot your password?

Or register your new account on DocShare.tips

Hide

Lost your password? Please enter your email address. You will receive a link to create a new password.

Back to log-in

Close