The US has to raise its debt ceiling before June 1 to keep the world’s largest economy running. If it doesn’t, all hell will break loose. But the Democrats under Joe Biden can’t seem to reach a consensus with the Republicans in opposition.

Share Market Live

NSE

Yes, history stands witness that these debates in the US have never spiralled down to default, however close they might have been. The amount of money that the American government is allowed to borrow has been raised 78 times since 1960, as documented by the American media outfit, NPR.

Raising the debt ceiling may be better than the worst outcome of the ongoing negotiations between the Biden administration and the opposition. Even if they agree on the eleventh hour, there will be an impact on the markets and, by extension, on people who have their money riding on it.

Also Read | Republicans question debt ceiling deadline of June 1 as talks zero in on potential trade-offs

The best-case scenario is an increase in the debt ceiling. If the debt ceiling is raised, the US will borrow more money. How? The US Federal Reserve will issue bonds to investors who buy them in cash. A lot of cash would be sucked out of the market because, in an uncertain world, US treasury bonds are the safest bet. No one says no to that.

But that means, riskier assets like equities may suffer because a lot of money is moved to US bonds. This is what Rajat Bhattacharya, Investment Strategist at Standard Chartered, calls a “liquidity squeeze”. Lack of cash in the market forces a cap, or a fall, in prices of risky assets like stocks.

Also Read | A $1 trillion coin and the US debt ceiling deadline

However, according to him, there is an upside to the drying up of cash in the market. “If there is a liquidity squeeze immediately after the ceiling is raised, the Fed could stop quantitative tightening (QT). So that is an upside. So, they will try to offset the liquidity squeeze with ending QT sooner than we expected, and we were expecting it at the end of this year,” he said.

Also Read | Debt ceiling talks grind on, but Republicans say there's a 'lack of urgency' from White House

Quantitative tightening is the term used to describe the recent reversal of easy money policies undertaken by the US Federal Reserve to help the US economy recover and grow faster. This has included 5.25 percent interest rate hikes in the last nine instances.

The potential increase in the US debt ceiling, followed by an inevitable tightening in the money market, may lead to a faster end to the Fed's fight against inflation, according to Bhattacharya.

Meanwhile, Gary Schlossberg, Global Strategist at Wells Fargo Investment Institute said, “It looks like the deal will be consummated sometime over the weekend and that will trigger a brief risk-on trading, as I said, stock markets in the US and overseas will benefit.”

Talking about the Fed rate hike, he said, “We do think there is a good possibility of at least one more rate hike given the inflation news, the resilience of the economy, if in fact, the economy begins to lose momentum during the closing months of 2023, we are more inclined toward a Fed pause; rate cuts really not coming until we are well into 2024.”

For more details, watch the accompanying video

Also, catch all the live updates on markets with CNBC-TV18.com's blog

(Edited by : C H Unnikrishnan)

First Published:May 24, 2023 9:52 AM IST