How does the debt ceiling work?
The Federal government has many legal and financial obligations to pay, such as Social Security, Medicare benefits, military salaries, interest on national debt, and tax refunds, to name a few. The government primarily pays for these expenses through income tax payments. However, these have never been sufficient in paying all of the obligations. Therefore, the government borrows money and accumulates debt. Congress is constitutionally required to authorize the issuance of debt, but they have set a limit on how much the federal government is allowed to accumulate. This is commonly referred to as the “debt ceiling”. To borrow more money, once the government has hit the cap, Congress must decide to raise the ceiling to allow for more accumulation. Otherwise, the government would default on some or all of their payments. Congress has increased the debt limit 78 times since 1960, when the system was put into place.
What is happening in 2023?
Technically, the government hit the debt limit of $31.4 trillion in January of 2023. They have since been using investment tools to keep payments flowing. However, as soon as early June, they could run out of options and the US could default. If this was to happen, there would be significant consequences, as discussed below.
In the past, increasing the debt limit was a relatively quiet and non-controversial affair, because no one in Washington has any real incentive to see the US default. However, in 2011, the last time the debt ceiling was significantly increased, there was a significant political battle over the debt. It was not clear until the very end that Congress was going to reach a compromise. In 2023, a very similar battle is being fought by the government. Lawmakers try to tack extraneous priorities onto bills that are seen as must-pass, which creates a target for these political fights. For example, with the bill today, Congress is specifically arguing around tighter requirements on government aid recipients in the Federal anti-poverty programs. Although this is related to the future government’s spending and debt, again, it is an added policy that is creating conflict around paying for the government’s current debts.
How does this impact investors?
The government has never defaulted. This is a significant reason why US treasuries are the most trusted debt vehicle in the world. Investors believe that the US will pay their debts. Therefore, if the country actually does start to default and their credit rating drops, there will be vast ramifications on the pricing of not just Treasury bonds, but all US bonds. In fact, the markets have already started to show some pricing stress around short-term Treasuries. Right now, yields on one-month T bills (5.62%) are well above the yields for 10-year (3.75%) and 30-year Treasury bonds. This inversion of yields reflects concerns and a pessimistic view about the economy in the near future, which impacts the stock and bond markets as a whole.
More importantly if the US government defaulted, many people would not be able to pay their bills, because so many rely on government stipends, Social Security, Medicare, or other forms of government aid to survive. These impacts would ripple across the entire economy and immediately throw the country into a recession that could be severe. No one wants this.
Is there another way?
It is almost unimaginable to comprehend all the consequences caused by the government defaulting, so chances are extremely high that they will reach a compromise and increase the debt ceiling once again. But this continues to beg the question of “what if”, as each time the debt cap is discussed, and the government takes longer and longer to reach a decision. Most experts agree that the current debt limit process is inherently broken. It does not force the government to actually reassess debt and spending priorities. Instead, it pushes the problem to future lawmakers as bills are passed to continue to spend money the US does not have. Many have suggested abolishing the debt limit or a system where Congress agrees to increase the debt limit frequently when they pass legislation. Other less popular proposals include raising the cap so high that the next debate is stalled for decades. However, as of today, no one can agree on a solution to the problem. Furthermore, the US cannot wait for one, because the government needs the money now to pay for existent policies and programs.
What, if anything, should investors do now?
As previously mentioned, the government is most likely going to reach a decision prior to default. However, there are still ramifications on investments as Congress continues to stall their discussions. Investors should expect volatility to increase in both stocks and bonds as the markets digest and react to news from the Congressional floor in the coming weeks. Furthermore, if the economy does slow or contract or the unthinkable happens and the United States does default on its debt, high-risk debt instruments such as corporate junk bonds or emerging market bonds will come under the most pressure. However, this should not cause investors to panic and make rash decisions. The best thing for an investor to do is talk to one of our financial advisors to understand the direct impact the government’s debt ceiling has on their investments. Please, find a list of our advisors on our website or reach out directly to Anna Fanning at afanning@g5financialgroup.com.
Sources:
Nine questions you may have about the debt ceiling : NPR
How to protect your investments in the debt ceiling standoff (msn.com)