May 18, 2023 Debt Ceiling: Should Investors Worry?
The U.S. debt limit – commonly called the debt ceiling – is the total amount of money that the U.S. government is authorized to borrow. When the debt limit is reached, the government can no longer borrow money to cover its obligations. Congress has raised or suspended the debt ceiling over one hundred times since WWII, usually with no controversy (see chart below) (1). From time to time, however, the debt ceiling and the threat of default on interest payments has been used in political gamesmanship.
Standoffs over the debt ceiling have played out in Washington many times before, but with thin majorities in both the House and Senate, finding common ground may be more difficult than previous years. Our base case remains that Washington will raise the debt ceiling and default will not take place – like it has every single time before. However, the negotiations will likely be noisy and come down to the last minute, creating volatility in markets.
Everyone has bills to pay, including the U.S. government. To meet its obligations (which include paying military salaries, retiree benefits, interest on national debt, etc.), the Treasury sells bonds (i.e., issues new debt) to investors across the globe. The U.S. government consistently runs a budget deficit (meaning it spends more than it takes in), which forces the Treasury to issue even more debt to pay its outstanding obligations.
U.S. Treasury’s are arguable the safest asset in the world and the U.S. dollar has been the reserve currency of the world for decades. This has created strong demand for U.S. debt, even at low interest rates, and has allowed the U.S. government to live beyond its means for many years. As a result, the stock of national debt has continued to rise.
The U.S. reached its debt limit of $31.4 trillion in January and has since been relying on its cash balance and “extraordinary measures” to fund its obligations. The Congressional Budget Office (CBO) and Treasury Secretary Janet Yellen expect the U.S. could run out of funding by early June but the exact date is uncertain.
Oddly, the raising of the debt ceiling is a separate process from the budget setting process. The debt ceiling needs to be raised to meet current obligations already authorized by Congress. The budget is passed by Congress and signed by the President every year, whereas the debt ceiling issue comes up only when we have increased our debt enough to need reach the debt ceiling. Lifting the debt ceiling does not authorize any new spending.
What are the potential outcomes if the debt ceiling isn’t raised?
Without the ability to issue new debt, the government would have to rely on current cash on hand (and incoming cash) to make its payments. So, the Treasury would be able to make some payments—just not all of them. In 2011 and again in 2013, Federal Reserve and Treasury officials developed a plan in case the debt ceiling wasn’t addressed in time. At that time, they determined the “best” course of action would be to prioritize interest payments over payments to households, businesses, and state governments.
The biggest risk around the debt ceiling is the potential for an economic contraction if the Treasury is forced to reduce spending. If the Treasury prioritizes interest payments, other expenses such as government salaries, military funding, and social security payments could be suspended. Such forced spending changes would have negative consequences for the economy, consumer confidence, and financial markets.
We think the risk of an actual default is extraordinarily low. Markets have never priced in more than a very low probability that the debt ceiling crisis causes a major default. The U.S. could default on its interest payments, but this would likely be extremely negative for financial markets.
Should such a debt default occur, then we are in uncharted waters in terms of market and economic impact. A missed interest payment would likely spark an outcry in the markets, accompanied by extreme volatility. Such a crisis would likely put the political gears in motion and a deal would be worked out. Hopefully, it doesn’t have to get to this though.
Historical analogs suggest a likely period of elevated market risks.
- In 1979, a breach of the U.S. debt limit left the government temporarily unable to cover its obligations, leading to a technical default and a surge in short-term rates. This case was quickly resolved following an increase in the debt ceiling, and confidence in the full faith and credit of the US government was restored as lenders were paid back.
- The most recent instance of a debt limit breach occurred in 2011, resulting in a sovereign downgrade by S&P and a spike in the VIX to its third highest level in the last 15 years (only the Global Financial Crisis and the start of the COVID-19 pushed it higher). Specifically, investors endured a -16% drawdown in the S&P 500.
- If things proceed in similar fashion this time around, we expect the greatest impact to be on U.S. Treasuries maturing around the time the debt limit is breached and on stocks most sensitive to government spending.
There’s no good way for investors to prepare for a doomsday scenario where the U.S. defaults on its debt and markets lose confidence in U.S. Treasuries. Diversification to non-U.S. investments, gold and cash could provide protection, but in general, a U.S. default is likely to lead to a very bad outcome for financial assets and global economies.
Fortunately, for now, we have every indication that a default remains a very remote possibility. All past episodes of debt limit negotiations have been resolved without lasting consequences. While uncertainty around the debt limit can be unnerving for investors, we take comfort in the fact that the full faith and credit of the U.S. Treasury has always been honored, and we remain confident that a default on Treasury debt obligations is a very low probability outcome.
1) Fidelity Management & Research
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