The debt ceiling is back

The suspension of the US debt ceiling agreed in May 2023 ends on 1 January 2025. The limit will then be reset at whatever the national debt stands at, roughly $36 trillion. The clock on Washington’s next financing drama starts ticking again.

The deal that suspended the limit, the Fiscal Responsibility Act, was struck between President Biden and the Republican House speaker at the time, Kevin McCarthy, only days before the Treasury said it would run out of cash. It capped some discretionary spending and pushed the next fight past the election. That fight nearly arrived early: this month Donald Trump demanded that Congress raise or scrap the limit as part of a stopgap spending bill, the House rejected his preferred version, and the bill that eventually passed to avert a government shutdown left the ceiling untouched.

Counting down to the X-date

The Treasury will have to start using extraordinary accounting measures straight away and run down its cash balance at the Fed to avoid a technical default. A Republican government in control of both Congress and the White House makes a dangerous stand-off less likely. The ceiling will still hang over every negotiation on tax and spending. Once again the Treasury is managing its debt on borrowed time.

Extraordinary measures are accounting devices the Treasury has used many times. The most important is suspending new investments in certain federal employee retirement funds, which frees room under the limit, with the funds made whole once the ceiling is lifted. Combined with the cash in the Treasury's account at the Fed, those measures usually buy several months. The X-date, when the money would run out, depends on the timing of tax receipts, and April's tax season can extend it considerably.

How the bill market shrinks

The first effect falls on the market for Treasury bills. Unable to increase its total debt, the Treasury pays for the government's spending by running down its cash balance and cutting new bill issuance. Fewer bills means less supply for money-market funds, which hold large amounts of them, so bill yields tend to fall relative to other short-term rates and more cash moves into the Fed's overnight reverse repo facility. As the Treasury spends down its account at the Fed, reserves flow back into the banking system, which eases funding pressures for a while.

The reverse happens when the ceiling is lifted. The Treasury rebuilds its cash account quickly by issuing a flood of bills, which drains reserves and can tighten money markets abruptly. After the 2023 deal it issued an enormous volume of bills in a matter of months. The same pattern is likely this time, and it would coincide with the Fed's continued shrinking of its own balance sheet.

Lessons from 2011 and 2023

Standoffs have cost the country before. In the summer of 2011 a divided Congress took the country to the brink before agreeing to raise the limit, and S&P cut America's credit rating from its top grade for the first time. In 2023 bills due around the expected X-date traded at a premium yield as investors avoided the securities most at risk of a delayed payment, and Fitch downgraded America in August, citing repeated brinkmanship and the erosion of governance. Neither episode ended in default, but each left a lasting mark on how rating agencies view American politics.

Why one-party control may not help

A unified Republican government removes the classic cross-party standoff, but it does not guarantee a smooth increase. The House majority is very narrow, and a group of Republicans has long refused to vote for a higher limit without deep spending cuts. Party leaders have floated raising the ceiling through the budget reconciliation process, which needs only a simple majority in the Senate, as part of the same package that extends Mr Trump's 2017 tax cuts. That ties the fate of the debt limit to the most complicated piece of legislation of the year.

That linkage creates its own risk. If negotiations over the tax bill drag on, the X-date could arrive before the bill is ready, forcing a separate vote that some Republicans would refuse to support and Democrats would have little reason to help pass.

The case for calm

The optimistic reading is that nobody in power wants a default, and that Mr Trump's own push to scrap the limit shows the White House will not use it as a weapon against itself. The Treasury has ample tools to manage for months. Markets have also grown used to these episodes, and have treated each of them as political theatre with a known ending.

That familiarity is itself a risk. Each round of brinkmanship has come closer to the edge before resolving, and a market that assumes the outcome is certain is poorly prepared if politics produce a mistake.

What to watch

The Treasury's formal notice that it has begun using extraordinary measures will start the countdown. Estimates of the X-date from the Treasury and the Congressional Budget Office will follow, probably pointing to the summer. The size of weekly bill auctions will show how quickly the Treasury is running down its cash, and yields on bills maturing around the X-date will show whether investors are nervous.

Washington’s holiday from the debt limit is over. Bill issuance will shrink as the Treasury stretches its cash, and a fight over the ceiling will probably get tangled up with the tax bill by the summer. Expect the limit to be raised in the end, but only after a period of shrinking bill supply followed by a sudden flood, with money-market funds and leveraged borrowers in the repo market feeling each swing.