What the Looming Debt Ceiling Deadline Means for Investors

The federal debt limit is once again in the news as the country rapidly approaches a critical deadline on June 1. Investors are understandably nervous about Washington failing to reach an agreement. The possibility that both sides don’t agree would be self-inflicted pain. While we expect Washington to sort this out, we believe it will be a dramatic process.  

It's worth reviewing what the debt limit is and is not. In simple terms, the federal government borrows money to pay its bills by issuing Treasury securities. This is necessary because the federal government often operates with a deficit whereby spending (on defense, Social Security, emergency pandemic stimulus, and more) exceeds government revenues (which consist primarily of tax revenues). While tax revenues increase as the economy grows (even without raising tax rates), they have been outpaced by spending over time. This borrowing adds to the national debt which hit the $31.4 trillion debt ceiling in January. Since then, the Treasury Department has been employing what it calls "extraordinary measures" to ensure that the country does not default on its obligations.

The debt ceiling is a mechanism that requires Congress to approve additional borrowing above these levels. Thus, what makes this discussion confusing is that the debt ceiling is not directly about government spending. Spending has already been authorized through the normal budget process that takes place each year.

The debt ceiling is about whether the government can and should pay its bills. This is akin to signing the papers for a new car then afterwards requesting an increase to your credit limit. For most of us, the decision to buy something coincides with the assessment of whether we will/can pay for it. In contrast, the Congressional process for approving a budget by September 30 each year is separate from whether the Treasury can pay the bills.

The large national debt is a controversial topic that impacts the economy and markets in complex ways. At the moment, Democrats, who control the White House and Senate, and Republicans, who control the House of Representatives, are in a standoff. On April 26, the House passed a debt limit bill by a narrow vote margin of 217 to 215. This would increase the debt limit through March 31, 2024 or until the national debt increases by another $1.5 trillion. However, it also includes provisions such as discretionary spending limits, the repeal of renewable energy tax credits, increased work requirements for benefits programs, and others. This makes it politically fraught and thus unlikely to pass, in current form, the Senate and be signed into law.

There is plenty of political grandstanding around this issue with each side trying to gain the upper hand. Similar debt ceiling standoffs have occurred over the past decade with the limit suspended and raised in 2013, 2014, 2015, 2017, 2018, 2019 and 2021. According to the Congressional Research Service, the debt ceiling has been raised 102 times since World War II.

Fortunately, despite the headlines and investor concerns, these episodes historically have little long-term impact on markets. The U.S. has never defaulted on its debt, and nearly all economists and policymakers agree that doing so would lead to turmoil in the financial markets and increase borrowing costs for businesses and everyday citizens. This risk is evident in the bond market with a sharp jump in Treasury rates with maturities around the debt ceiling deadline, and much lower rates thereafter.

An exception to markets staying relatively calm occurred in 2011 when a similar standoff led Standard & Poor's, a credit rating agency, to downgrade the U.S. debt. The stock market fell into correction territory with the S&P 500 declining 19%. Ironically, the prices on Treasury securities increased during the 2011 debt ceiling crisis because, even though these were the exact securities being downgraded, investors still believed they were the safest in the world at a time of heightened uncertainty. The debt ceiling was eventually raised and a new budget was approved, allowing markets to bounce back.

I sometimes feel like the message to every blog is basically, stay the course. Today is not different. While the debt ceiling has and will likely continue to be a bargaining chip in Washington, failure to reach an agreement has too high of a political cost for either party to endure its pain for long. We don’t believe it changes the outlook for the long-term investor.

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