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Conversations around the U.S. debt ceiling are likely to pivot to a short-term debt limit increase that will lessen market fears, note Washington Policy Analysts Ed Mills and Alex Anderson.

The latest projections from Treasury and the Congressional Budget Office (CBO) put the debt ceiling “X-Date” as soon as June 1 – earlier than the markets and D.C. expected. This significantly raises the stakes on the negotiations over the course of this month, with President Joe Biden proposing a May 9 meeting between him and House and Senate leaders (the next day Congress is in session).

The new deadline not only leaves even less room for error but also increases the potential for a short-term extension to remove the risk of default while providing time for further budget negotiations. Among the key players in this debate, we are most focused on Senate Republican Leader Mitch McConnell (R-KY), who has been a key player in previous negotiations. Overall, we view the earlier “X Date” as increasing the risk to equity markets in the near term but continue to believe a deal will be struck to avoid default.

Early June “X-Date” increases drama around debt limit. The latest projections from Treasury Secretary Janet Yellen pointing to the U.S. government being unable to satisfy payments on obligations as early as June 1 or “a number of weeks later than these estimates” will increase market concern over the ability of Congress to reach a deal on a shorter than anticipated timetable. An additional analysis released by the CBO will add credibility to Yellen’s projections with the latest CBO estimates also seeing a higher risk of an exhaustion of extraordinary measures in early June due to lower-than-anticipated tax receipts in April. Alternatively, any perception that Yellen’s projections are unrealistic and are meant to serve as political leverage could poison the well during the negotiation process. Regardless, we expect Congress to now approach this issue with more urgency, with credible projections pointing to the June-July period for necessary action to avoid default.

Conversations are likely to pivot to a short-term debt limit increase that will lessen market fears. While the initial market reaction may be negative around the June projections, we expect Congress will need a longer runway, which raises the odds of a short-term debt limit extension. A pivot in this direction has recent precedent but can be viewed as more of an uphill battle with greater resistance to “clean” increases in the House. Congress temporarily extended the debt limit for two months in October 2021 as a short-term measure before extending it on a longer-term basis in December 2021. Reports indicated Republican lawmakers have considered an extension of the debt limit until September 30 over the course of this year. An extension through the fall would coincide with the FY24 government funding deadline and provides a clear catalyst to wrap-up negotiations.

Eyes on the Senate and Mitch McConnell’s demands. With negotiations not set to start until at least May 9 and an “X Date” as early as June 1, a discussion of arcane Senate procedures and timing will quickly come into focus. Generally speaking, there is likely only time for the Senate to pass a bill once, making negotiations in the Senate increasingly important. Separately, any short-term extension would likely be developed in the Senate under a deal brokered between Majority Leader Chuck Schumer and Minority Leader McConnell. Senate Republicans may once again propose a temporary filibuster rule exemption for the debt limit that allows Democrats to move an increase on a party-line vote. However, this would be tied to conditions with the 2024 race in mind that put Democratic senators from swing states in a tough political position. These policy concessions could include market-relevant provisions such as Inflation Reduction Act (IRA) repeals or guardrails. McConnell has a stronger hand in this round of negotiations as a bill voted out of the Senate would need to be approved by a House Republican majority. Notably, Senator Joe Manchin is signaling he will push for some IRA repeals as part of the debt limit process. At this stage, we view this as political messaging, given the recent announcement of West Virginia Governor Jim Justice’s candidacy against Manchin in the 2024 Senate race. However, Manchin has a demonstrated history of effectively using leverage in key legislative negotiations. ESG: The most likely target would be guardrails that limit the expansion of tax credits for EVs through economic arrangements that are not pure Free Trade Agreements (FTAs), which has been a key point of frustration for Manchin as seeks flexibility to extend applicability to the EU and Asian allies. We will be watching to see if any other policy provisions could be attached with market impact related to IRA implementation and the ultimate direction of fiscal reforms as the process comes together.

Where are we in the debt limit process? D.C. has been in the “political theater” stage of the debt limit negotiations, which is a factor that can temporarily raise market concerns. With an “X-Date” now less than a month away, we are entering into the full negotiations phase. Both Republicans and Democrats are using the issue for political messaging purposes following the passage of the House debt limit bill – an opening for negotiations with the White House and Congressional Democrats. Currently, there is a divide among Democrats on the best strategy between direct negotiations and holding to their “clean” debt limit raise stance (a position that Democrats stuck to in 2021). However, that “clean” debt limit bill moved under unique rules which suspended the filibuster – a set of events that is unlikely to be repeated given Republican control of the House. As such, we see negotiations on some fiscal reforms as the most likely (and probably necessary) path forward.

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