UK market chaos highlights risks of debt ceiling hijacking

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Illustration: Sarah Grillo/Axios

British Prime Minister Liz Truss’ defenestration suggests the risks of a standoff over the US debt ceiling could be higher than when such tactics were last deployed.

Why is this important: Midterm elections in the United States could give Republicans control of the House of Representatives. This raises the specter of a repeat of the debt ceiling crisis that erupted about a decade ago.

  • But as the Truss debacle shows, current market conditions could yield a more explosive outcome.

Driving the news: Truss’s resignation came Thursday just weeks after his first budget plan caused wild swings in UK bond prices and the pound.

The context: The Truss government misjudged the market backdrop, in which it unveiled plans for bigger-than-expected tax cuts, implying bigger budget deficits to come.

  • For much of the past two decades, extremely low inflation and the calming influence of central bank bond-buying programs have kept markets relatively calm, despite growing budget deficits.

Yes, but: Inflation changed everything. Instead of buying bonds to keep rates low, central banks are reducing their holdings to drive rates up. This forces market participants to buy billions of dollars of additional government debt each month. If they are hesitant to do so, it results in higher returns and more violent market movements.

Meanwhile: Republicans appear poised to regain control of the House of Representatives in next month’s midterm elections — and with it the fiscal reins of the federal government.

Rollback: After taking control of the House in 2010, Republicans used similar tactics, leading to a series of budget stalemates.

Our thought bubble: Taken in isolation, the damage caused by these fights against the debt ceiling seems limited.

  • But remember, in 2011 the Fed set interest rates at almost zero.
  • The Fed wasn’t throwing nearly $100 billion of bonds into the market each month.
  • Inflation was far from its current level of more than 8% per year.

The bottom line: Nobody knows what the real risks inherent in the bond market are right now — not even the Fed, whose officials were nervously asking about it, according to a New York Times report. A messy fight against the debt ceiling or, oddly enough, a complete default, would almost certainly reveal them.

  • And as Truss discovered, the process could be unpleasant for politicians.
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