Could a US debt ceiling resolution actually cause a stock market crash?

ASX 200 investors are celebrating news that the US debt ceiling may be lifted, avoiding a catastrophic default. But could the resolution itself usher in a stock market crash?

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Key points

  • The ASX 200 is up 1% on Monday
  • United States officials have moved closer to raising the US debt ceiling
  • The US$1 billion-plus of Treasury bills needed to fund the higher debt limit could drain liquidity from already troubled banks and jittery stock markets

The S&P/ASX 200 Index (ASX: XJO) is rallying today amid news the US debt ceiling crisis may be approaching a resolution.

In late morning trade on Monday, the ASX 200 is up 1.1%.

That's a welcome change from last Thursday when the benchmark index closed down 1.0% as investors fretted the world's top economy might default on its mammoth debt pile.

What's happening with the US debt ceiling crisis?

As you're likely aware, the United States has once more exceeded its self-imposed debt limit.

The US debt ceiling currently stands at an eye-popping US$31.4 trillion (AU$48.2 trillion).

To put that into perspective, the US federal government is in debt to the tune of some AU$6,000 for every man, woman and child on the planet. And that doesn't even include the nation's state and local government debts.

Little wonder then that US treasury secretary Janet Yellen cautioned, "Failure to meet the government's obligation would cause irreparable harm to the US economy, the livelihoods of all Americans and global financial stability."

It looks like that particular harmful scenario may again be avoided.

The US debt ceiling has been lifted 78 times since 1960. The last US$2.5 trillion increase came less than two years ago, in December 2021.

And on Saturday news broke that US President Joe Biden and Republican congressional leader Kevin McCarthy reached an initial compromise to lift the federal government's borrowing limit. Though that still needs to gain the approval of Congress.

Yet while avoiding a default is most likely the best recourse, as Yellen pointed out, might this resolution still usher in a stock market crash?

How the higher debt will be funded

The concerns over a potentially large impact on global stock markets, including the ASX 200, stem from how the higher US debt ceiling will be funded.

The federal government borrows money by issuing shorter-term Treasury bills (T-bills) and longer-term government bonds.

And JP Morgan expects the government will issue around US$1.1 trillion of new T-bills over the next seven months to help fund the US debt ceiling. These will likely be issued at relatively high yields in light of higher global interest rates.

Amy Xie Patrick, head of income strategies at Pendal Group, warned of the potential impact on already stressed banks, as well as a liquidity crunch for other assets like equities.

According to Xie Patrick (quoted by Bloomberg):

If a whole bunch of yieldy T-bills are about to be issued, that poses the risk of sucking liquidity away from other assets, and of further draining deposits from banks. The continued use of the Bank Term Lending Facility is a sign that regional bank liquidity stresses are far from over, and that parts of the financial system remain fragile.

As we witnessed in March, should the banking crisis in the US intensify, that in itself could be enough to send the ASX 200 and global stock markets spiralling lower.

Alex Lennard, investment director at global asset manager Ruffer, shares those liquidity concerns (courtesy of Reuters).

"Our concern is that if liquidity starts leaving the system, for whatever reason, this creates an environment where markets are crash prone," he said. "That's where the [US] debt ceiling matters."

We'll leave off with Mike Wilson, equity strategist at Morgan Stanley.

Wilson cautioned that the issuance of more than a billion dollars of T-bills "will effectively suck a bunch of liquidity out of the marketplace and may serve as the catalyst for the correction we have been forecasting".

While the US debt ceiling crisis may be shaping up to be a 'stuffed if you do, stuffed if you don't' scenario, today, at least, ASX 200 investors are making hay.

Motley Fool contributor Bernd Struben has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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