The first quarter of 2023 saw continued inflation, Fed rate hikes, and turbulence in the banking sector. Despite these negative headlines, most markets performed respectably well, clawing back some of their losses from 2022. The NASDAQ 100, often viewed as a barometer for tech stocks, led the way with a 20.77% return. While a stellar return, this was not enough for that index to regain losses from its all-time highs. In the fixed income market, rates on longer dated securities have come down, with the 10-year Treasury bonds yielding 30 bps less at the end of Q1 than at the beginning. These solid past quarter market metrics are certainly a welcome break from the depressed returns of last year. Looking ahead, we wanted to take a deeper dive into a topic that may not be top of mind right now but will become so as we approach the summer: the debt ceiling.
On January 19th, 2023, the United States hit its statutory borrowing cap of $31.4 trillion. This cap, known as the debt ceiling (or debt limit), is the amount of outstanding U.S. federal debt that Congress can authorize. No additional debt can be issued by the United States until the limit is raised, with the operation of the government currently funded by “extraordinary measures” of the U.S. Treasury. These extraordinary measures delay the need to borrow additional funds for a short time but are expected to run out by June of this year, according to the Brookings Institution. With this timetable in mind, CWAG believes it is important to provide our clients with a high-level overview of what the debt ceiling is, the historical context of the U.S.’s previous brushes with the limit, and how this may impact you.
Until 1917, each time the United States needed to raise money, Congress would individually authorize each debt issuance. However, pressed by the massive increase in military spending due to the first World War, Congress passed a law that gave the federal government a set borrowing limit. Since that time, whenever the government needs to pay for spending that requires debt financing above the debt limit, the limit needs to be raised. This has been done 78 times since 1960, when the Treasury started tracking increases. Through successive debt limit hikes and continued deficit spending over the years, the United States has accrued a staggering $31.4 trillion in national debt, per the Congressional Budget Office.
“Through successive debt limit hikes and continued deficit spending over the years, the United States has accrued a staggering $31.4 trillion in national debt.”
This chart below visualizes the accumulated debt of the U.S. from 1970 through 2022.
Some people find an analogy to the debt limit in a credit card. When you max out your credit card, you need to raise your credit limit if you want to continue spending. However, this analogy falls short because the government does not budget like normal households. Congress can (and does) pass spending bills without stopping to consider if they have the financing capacity to pay for them. This means that government spending must by law happen, regardless of if they have enough capacity to borrow to pay for it. When Congress does not have enough borrowing capacity, they must raise the debt ceiling to pay for spending that they already approved. This has been done every single time that it was necessary in the past, so we have never seen what would happen if the debt ceiling were not raised, but most experts believe some sort of sovereign default would occur. This would be the first such default in our nation’s history.
This is not to say we have not come close. In the Spring of 1979, retail investor interest in short-term Treasury bills was so high that a minor glitch in the equipment used by the Treasury to print checks caused some Treasury bill holders to not get their money on time when their bills matured. In a sense, this could be considered a default since some debt holders received delayed payments. However, because the delay was only a few days and due to equipment issues (rather than insolvency), analysts did not consider this a default and it has largely been forgotten by history. A far more serious brush with default occurred in 2011. Back then, the Treasury estimated that it would exhaust its “extraordinary measures” by August 2nd of that year. Partisan gridlock over the budget led to a standoff until the bitter end, with a legislative package that included raising the debt ceiling and decreasing future spending. This package was finally agreed to and signed into law right at the deadline. Per ABC News reporting at the time, the Dow Jones Industrial Average dropped 4.31% on August 4th in response to the debt brinksmanship and in anticipation of credit downgrades for the U.S. by August 5th. Standard and Poor’s did in fact downgrade the credit rating of the United States from AAA to AA+, the nation’s first downgrade in its history.
The 2011 debt limit showdown could provide the best insight we have into what unfolds should the U.S. not raise the debt limit when the Treasury has run out of cash to fund the government’s expenditures. When the Treasury reaches this point in the Summer of 2023, the only cash available to spend would be whatever came into the Treasury through day-to-day tax receipts. The government will then face the uncomfortable choice of what spending to prioritize with its limited resources. On the one hand, the Treasury could cover interest and principal payments on the nation’s debt to keep bondholders whole. This would divert funds from other mandatory spending, ranging from Social Security to military pay to scientific research. On the other hand, Treasury could attempt to pay for these programs to the full extent that it could, and ignore the bondholders, resulting in a classic default.
While neither option is appealing, servicing the nation’s debt is likely to take priority. Since Treasury bonds form the reference point for almost all credit instruments, from your home mortgage interest rate to trillions of dollars’ worth of derivatives contracts around the globe, timely payment on this debt is critical to the financial system. However, the shock to the economy from the abrupt cessation of government spending could be tremendous, not to mention the human cost of not covering our safety net programs or paying our men and women in uniform, etc. Even without a default, a delay in satisfying its obligations could damage the United States’ reputation as a reliable debtor.
The consequences of not raising the debt ceiling are serious, as it would likely lead to default. However, it is important not to dwell too much on the nebulous what-ifs should an unprecedented default occur. Charles Schwab states in their January article on the subject, that they believe a default is highly unlikely. They note that “Congress has always managed to find a way to reach an agreement.” Perhaps you are not persuaded by this argument, thinking this time is different. While that may be the case, markets certainly have not viewed the possibility of default this way. Year-to-date, the S&P 500 is up 7.64%, suggesting that equity investors are not too concerned about the threat of default. Perhaps more telling, 10-year Treasury yields are down 7.78% YTD. If fixed income markets were concerned about the U.S. meeting its financial obligations, rates would likely behave much differently.
“Congress has always managed to find a way to reach an agreement.”
In conclusion, we believe that it is important for our clients to have the facts on the debt limit well ahead of when the drama of raising it becomes a fixture of the news. By the time this happens, pundits may try to spin the news to benefit their political agenda or increase ratings. If we focus on the facts, we can take stock of the situation in a rational way instead of succumbing to the drama that we may be subjected to. Yes, a default would be a financial disaster, but there is still plenty of time for Congress to make a deal to raise the debt limit. History shows that they always have. In addition, market participants with the most to lose are not pricing in a default. Finally, if you were to give into fear and leave the
market altogether, there is a very likely chance that your portfolio will underperform your goals. Below is a chart of the S&P 500 from 2011 through today. If you look close enough, you can see the dip on the left-hand side that corresponds to the market turbulence of the debt ceiling fight of 2011. If you panicked and exited the stock market at that time, you would have missed out on a 264.26% return through today generated by one of the all-time great bull markets. The cost of fear oftentimes can be quite expensive; therefore, we continue to recommend focusing on your long-term plan during times of short-term volatility.
Source: CNBC
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