US political outlook 2022

How the debt-ceiling crisis could play out: four scenarios

  • The Treasury secretary, Janet Yellen, has said that the federal government could run out of funds to pay its bills as soon as June 1st—the “X date”. 
  • The X date could come a few weeks later, but this will depend on the Treasury’s cash flows, and is likely to arrive abruptly. 
  • Although Democrats and Republicans remain far apart on the issue, a potential agreement to raise the debt ceiling and cut spending is starting to take shape. 
  • Our core forecast is that a compromise deal will be reached just before the X date, with some modest negative economic effects. 
  • However, there is a significant degree of uncertainty. EIU has outlined four scenarios for how the debt-ceiling stand-off could play out, along with the economic impacts of each.

The US government has never defaulted on its debt, but it does occasionally have showdowns over whether or not the ceiling will be raised. Tense negotiations last took place in 2011 and 2013; US fiscal agencies estimate that these stand-offs pushed total borrowing costs up by US$19bn and US$38bn respectively. Risks to the economy are even bigger this time, given that the US is on the edge of a slowdown and rising interest rates have already strained the banking system. 

There is a high degree of uncertainty over how debt-ceiling talks will play out. We outline several scenarios here, in order of likelihood. 

Core forecast: a negotiated compromise is reached at the 11th hour (50% probability)

The most likely outcome is that a debt-ceiling agreement is reached just prior to the default deadline. The Treasury will probably have enough funds to stretch for a few days or even weeks, but passing the symbolic June 1st date without an agreement would still destabilise markets. This scenario will have a range of economic consequences. We expect bond yields to rise across the board, potentially 25-50 basis points above current levels—similar to the effects of the 2011 debt stand-off. The US dollar is likely to depreciate modestly against major currencies over the next month as investors anticipate higher economic and financial risks. The dollar’s value is, to a large extent, based on global demand for US dollar-denominated securities, which would also soften. There is a high risk that credit rating agencies would downgrade the US rating, permanently raising borrowing costs and deepening the economic slowdown. 

The US debt ceiling has been increased 19 times since 2001, and currently stands at US$31.4 trillion.

There are reasons to be optimistic that a deal will be reached in the end. Democrats have signalled a willingness to negotiate the debt ceiling and spending in tandem (they had previously wanted to keep the two issues separate) and to repurpose unspent covid emergency funds (one element of the bill passed by House Republicans). Democrats are also likely to accept some 2024 spending cuts and caps on discretionary spending in the coming years. However, we expect them to resist cuts to renewable energy and other green incentives under the Inflation Reduction Act. 

In exchange, Republicans will have to accept more modest spending cuts than they would like. Reforms to ease the permitting process of major energy infrastructure projects—a long-standing policy goal of many Republicans, as well as moderate Democratic senator Joe Manchin—are likely to sweeten the deal for Republicans. The Republican House speaker, Kevin McCarthy, is likely to face a leadership challenge, given his tenuous hold on the position (a single House Republican is able to call a no-confidence vote). However, we believe that this scenario is his best chance of keeping the job. 

Plan B: Congress kicks the can down the road (30% probability) 

For now, the actual X date is a moving target. We expect tax revenue in May and June to remain well below previous-year levels, suggesting that the deadline will come earlier than many expect, probably in the first half of June. If leaders cannot reach an agreement by then, the next most likely alternative is that they would lift the debt ceiling marginally, delaying final negotiations until September. For this outcome to be viable, Democrats and Republicans would have to have fleshed out the structure of an agreement by June, with only the final details left to be negotiated after the debt ceiling is temporarily raised. Therefore, the end result, and the economic implications, would be broadly similar to our core forecast. 

This outcome would have a slightly more negative effect on the economy in June-September than our baseline scenario. We expect the 2024 budget negotiations to be even more fraught than usual, given the current level of partisan tensions. This increases the risk of a temporary government shutdown as both parties fight over spending plans. Adding the debt-ceiling question to the mix would aggravate investor fears. Relative to our baseline, this would weigh on asset prices and the US dollar, as well as raise bond yields and market volatility. 

Yields on most US Treasury bonds have been fairly stable since mid-April 2023. However, while yields on most short term maturities (three and six month bonds) remain comfortably within the federal reserve target range, between 5 and 5.25 percent, one-month bonds that mature around the debt ceiling X date shot up to around 5.8 percent in mid-May.

Downside: US briefly enters default (10% probability)

If no agreement on the debt ceiling has been reached by the time the Treasury runs out of funds, the US government could prioritise payments to bondholders by cutting spending elsewhere (for example, by pausing public investments or shutting down “non-essential” departments and services, such as National Parks). The government would protect essential payments, such as Social Security and Medicare payments (public pension and health services for retirees). 

This prioritisation would allow the government to continue meeting its debt payments for a short time, avoiding some of the worst financial and economic effects. However, this still amounts to a default, and it would seriously undermine US creditworthiness. In this case, we would expect the value of the dollar to fall sharply. We would expect bond yields to rise by a larger margin than in our core forecast while the US is technically in default; even once the crisis is resolved, borrowing costs would remain elevated. Asset prices would drop sharply as economic fears mount. We would expect US GDP to contract slightly in 2023 and to remain subdued in 2024. The US’s credit rating would be downgraded, which would keep the dollar weaker and bond yields higher than they were prior to the debt crisis throughout our forecast period (2023‑27). 

A worst-case default scenario is that the Treasury would exhaust its means to continue paying bondholders and the US enters a full default. The Treasury could take three potential responses, any of which would deepen the negative economic impact.

  • The maturity dates of mature bonds are extended by one day, postponing principal repayments on a day-by-day basis. 
  • The Treasury signals that it will not pay interest payments on the principal on the allotted day, amounting to a full default (even if interest is repaid later).
  • Unmitigated default: the Treasury does not extend the maturity or make interest payments. 

Upside: the debt crisis is resolved well ahead of the deadline (10% probability) 

There is a narrow window for the White House and Congress to resolve the debt crisis without more negative effects on the economy. The impact on financial markets and the economy has thus far been limited, but this is unlikely to continue. Yields on short-term government bonds that fall due in mid-2023 are rising in line with market jitters; by mid-May one-month Treasury bill yields were about 80 basis points above where they would normally be (at times of low market risk, short-term yields tend to trade at the bottom of the Fed’s target range, currently 5‑5.25%). 

Neither Democrats nor Republicans want to be seen to be making concessions unless as a last resort. However, if market indicators were to weaken further, including a sharp slide in asset prices and another rise in bond yields, this could force both parties to reach a deal ahead of the deadline. This would limit the economic impact to brief market volatility; asset prices would stabilise (but not rebound) and bond yields would probably fall back within the fed funds rate target range within a few days, easing pressure on banks.

The analysis and forecasts featured in this piece can be found in EIU’s Country Analysis service. This integrated solution provides unmatched global insights covering the economic, political and policy outlook for nearly 200 countries, helping organisations identify prospective opportunities and potential risks.