Debt ceiling impasse: U.S. is only a few cycles away from using legal loopholes like minting $1 trillion platinum coin to avoid default - RBC
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(Kitco News) With U.S. Treasury Secretary Janet Yellen’s June 1 default deadline kickstarting the U.S. debt ceiling talks again, RBC Wealth Management warned that this year's political and economic backdrop is "one of the most challenging."
And even though RBC ruled out a default scenario this time around, it did sound an alarm about how many more times the U.S. would be able to raise the debt ceiling without relying on legal loopholes such as the minting of a $1 trillion platinum coin.
"We believe a permanent solution by June 1 is very unlikely, but we would not be surprised if the parties were able to reach a stopgap measure that lasted until mid-June," Atul Bhatia, fixed-income portfolio strategist with RBC Wealth Management, said in a note Tuesday.
Yellen said Monday that the U.S. could run out of money to pay its bills by June 1 if Congress fails to raise or suspend the debt ceiling.
Lack of progress and the approaching X-date is impacting the markets this week, with equities selling off and gold rising above $2,000 an ounce.
"The cost to insure against a near-term U.S. default has spiked, with investors now paying a 1.77 percent premium for 1-year credit default swap protection. The previous record—which was less than half of current levels—was set during the 2011 debt ceiling negotiations," Bhatia pointed out.
A U.S. default is not a realistic scenario, but much damage can be done during the negotiation process, including adverse effects on economic growth.
The closer the U.S. gets to the default date, the worse the outcome, RBC said, outlining three potential scenarios.
Number one — if the debt ceiling is raised more than two weeks before the X-date, it's a good outcome. "We think this outcome is still possible, but unlikely and becoming more difficult as the political parties ramp up rhetoric," Bhatia said. "We would expect a meaningful, but likely short-lived, positive market response if the ceiling were raised in a relatively non-contentious manner."
The second scenario is a "bad" outcome — if the debt ceiling gets raised within two weeks of the X-date. This would be a repeat of the 2011 debt ceiling debacle when the debt limit was lifted last minute.
"We see a last-minute ceiling raise as likely to cause higher volatility and a potentially large drawdown in risk assets. Such a reaction may, in fact, be necessary to provide political cover to Congress to raise the ceiling. We anticipate a relatively fast recovery, but we are not convinced markets will return to the pre-drawdown level," Bhatia noted.
This scenario would weigh on growth in 2024. Plus, there is a risk of higher borrowing costs and the U.S. sovereign credit rating score to worry about. "One agency already took away AAA status from the U.S. after the 2011 debt ceiling fight, and a similar move by another agency could lead to forced selling by some investors," Bhatia explained.
And the third and worst-case scenario would be the use of a non-legislative action ( a loophole) to avoid default.
One potential solution would be minting a trillion-dollar coin. This is based on the broad language used in the law that dictates the mintage of coins. The exact wording can be found in subsection (k) of 31 USC 5112, which governs "Denominations, specifications, and design of coins."
It potentially authorizes the Treasury Secretary to mint any denomination platinum coin to fund the government.
The clause states: "The Secretary may mint and issue platinum bullion coins and proof platinum coins in accordance with such specifications, designs, varieties, quantities, denominations, and inscriptions as the Secretary, in the Secretary's discretion, may prescribe from time to time."
Another non-legislative solution would be to exchange existing Treasury bonds for ultra-high coupon bonds. "The debt ceiling is calculated on the face value of debt, so it would be possible to reduce the counted debt by reclassifying some principal repayment as interest," Bhatia described.
Using any of these options would trigger "a meaningful repricing in risk assets," leading to a loss of investor confidence.
"We do not see this as a likely outcome, but we do not think it is impossible," Bhatia added. "We are likely only a few negotiation cycles away from the U.S. being forced to rely on legal loopholes or commemorative coins to maintain performance on its debt."