The Looming Debt Ceiling & Market Implications
Treasury Secretary Janet Yellen recently stated that we may hit the debt ceiling as soon as June 1. Although we were warned earlier this year, concerns of a possible default are appearing prominently in financial media headlines as the deadline approaches.
What Is the Debt Ceiling?
The debt ceiling is the limit on the Treasury’s ability to issue new federal debt—meaning it’s a limit to how much the government is allowed to borrow to meet its existing legal obligations. The government instituted a debt ceiling in 1917 as part of the Second Liberty Bond Act to help fund the U.S. contribution to World War I. Since this time, the debt limit has been suspended or raised over 100 times.
Why Is the Debt Ceiling an Issue?
Without authorization to issue more debt, the Treasury may run short of funds to make payments on behalf of the government. They would run the risk of making delayed payments or even defaulting on obligations, including previously issued Treasury securities. We reached the federal debt limit of $31.4 trillion earlier this year. At that time, Yellen announced “extraordinary measures” would need to be taken to pay its bills. While failure to raise the debt ceiling could have catastrophic consequences for the economy, it’s important to note that we’ve been down this road before. History can be our guide and we highlight two recent years when the debt ceiling was at the forefront of market concerns:
The debt ceiling became an issue in 2011, leading Standard & Poor’s to downgrade the federal debt and reduce the country’s credit rating for the first time in U.S. history.
In 2013, tense negotiations over the debt ceiling brought the country to within days of default. Since then, the debt ceiling has been raised or suspended without much controversy.
What the Debt Ceiling Means to Markets
As the June 1 deadline approaches, we would expect market concerns to increase. In the near term, a threat to the creditworthiness of federal debt could cause downside volatility in stock markets, a rise in Treasury rates, and a weaker U.S. dollar. Eventually, market stress would likely pressure Congress to act, and they will likely suspend the debt ceiling for a period of time to get back to negotiating the fiscal budget. If political leaders begin working on solutions, markets would probably ignore the political posturing and resume focus on recession risk, inflation, and the Federal Reserve’s next moves on interest rates.
There are additional measures that the administration could take to continue paying its bills. An option that was considered in 2011 was for the U.S. to use its available resources to make payments to investors holding U.S. debt while foregoing payments to Social Security recipients, military contractors, and others. The administration could also issue some short-term, high-interest-rate bonds to extend the period for Congress to reach a deal. Short-term extensions would not be ideal, but they would provide additional time for Congress to act.
Bottom Line: Although investor concern regarding the debt ceiling is increasing, we expect the ensuing near-term volatility will subside over the long term, as they have in past negotiations around this issue. If this time truly is different, markets could become even more volatile, which we believe would present an opportunity for investors with longer-term time horizons. We believe that a “Kick The Can” scenario is most likely as a default approaches. Maybe an extension would last until the Fourth of July recess or maybe it would last until the fiscal year ends on September 30th. We will continue to monitor the situation and keep you updated along the way.
As always, please feel free to reach out to me directly with any questions. Thank you for the continued opportunity to serve you.