Given the press and the questions that clients are rightfully asking about the debt ceiling, we felt that some perspective may help.
For those unfamiliar with the debt ceiling and how the U.S. Treasury works, allow me to explain exactly what all the fuss is about. The federal debt ceiling is a limit set by Congress on the amount of money that the US treasury can borrow to fund government operations and make interest payments to people and institutions who own U.S. government issued bonds.
Over the past few decades, this spending limit has been reached multiple times (much like maxing out your credit card) and Congress has traditionally approved an increase in the spending limit, or debt ceiling, that keeps U.S. treasury moving. Again with the credit card analogy, This would be like maxing out at your credit card, then calling the credit card company and asking them to increase your limit so you can continue to borrow. Again, over the past decades, this spending limit has been reached numerous times, and the spending limit has always gone up. In fact, it’s never gone down.
Since the early 1980’s it has typically been a forgone conclusion that as the U.S. Treasury asks for an increase in what they can borrow, Congress grants that request and raises the debt ceiling. Regardless of who has had control of the House of representatives, the Senate, or the White House, the debt ceiling has always been raised as needed. There are times when, for political expediency the process is held up by one party or another hoping to gain something in exchange for their vote to raise the debt ceiling. As you can see from the chart below, there isn’t one political party or another that has exclusively raised the debt ceiling,
So why does this matter now?
It matters because the Treasury reached is spending cap in January. Since that time the Treasury Department has been using “Extraordinary Measures”, (accounting gymnastics if you will) to keep the government operating. This includes payments on US debt, payroll to government employees, funds necessary to run national parks, and Social Security and Medicare benefits. The treasury is now almost out of accounting options to keep the government funded, which means that if more money isn’t allowed to be borrowed, the operating expenses that I mentioned above and others cannot be paid for.
The United States has consistently maintained a AAA credit rating on its debt. This is why foreign governments, US citizens, and foreign citizens buy US treasuries, because the government guarantees these payments and the likelihood of default is, to this point, unheard of.
The Treasure Department estimates that they can pay for government expenses until the first part of June, which is quickly coming. This is causing anxiety with investors and the markets because the risk of default would affect the markets negatively, and possibly lower the credit rating of United States treasuries.
In the past several days some clients of asked what happens if the deadline isn’t met and the government runs out of money? My response has been, in part, let’s look at 2011, when that exact thing happened. In 2011 Republicans would not vote for a debt ceiling increase unless the Democrats repealed the affordable care act signed by President Obama. We reached a point where national parks ceased operations, and some payments that the government makes, other than to their own debt holders, were postponed. This turned out to be a political nightmare for both parties and Congress in general, and both parties agreed that this is not something that should ever happen again. Many in Congress today lived through that mistake.
The chart below shows Standard & Poor’s 500 index (The market). Just before some government facilities shut down and the market reacted negatively to that shut down. Further, one of the major credit rating agencies lowered the rating on US treasuries from AAA to AA+ which was the first time that US credit had been rated less than AAA.
As noted in the chart above, the downturn in the market in 2011 was quick, but was also short. The debt ceiling was raised and and the markets produced at 57.88% gain from just before the market sold off, and a 77.52% gain from the bottom of the downturn (Oct. 3, 2011) over the next four years. (Oct. 3, 2015). They say history doesn’t repeat itself, but it sometimes rhymes. Past market reactions can’t predict the future for certain, but they can be used for perspective. Whats more, a reduction in the Treasuries credit rating is not unheard of now, as it was in 2011. This may take some= of the “unknown” out of this unlikely scenario
Where do things stand tonight?
Per my former colleague at Charles Schwab and Co., Greg Valliere, who has followed government policy and market effects for over 40 years, he offered this take today;
Both sides are still far apart, with some Republicans questioning the validity of a June 1 “X-date.” They think default is not imminent. That viewpoint may gain adherents, because the Treasury Department is telling agency heads to slow down payments, the Washington Post reports this morning.
This tactic is part of a scenario that could avoid a default until late summer. How could this happen?
THE TREASURY COULD SLOW PAYMENTS — or sell assets — it could limp through June 15, when major quarterly tax payments are due. That would give the debt managers enough money to avoid an imminent default.
TREASURY OFFICIALS HAVE TOLD AGENCIES — such as the Defense Department and the Centers for Medicare and Medicaid Services — to slow down their process for submitting payments.
TREASURY ALSO COULD SELL BONDS held by some of the government’s massive trust funds, such as the Social Security Trust Fund or the Highway Trust Fund. That could raise tens of billions of dollars immediately, some experts say, and the trust funds could easily be made whole once the budget standoff ends.
AND TREASURY MIGHT FIND a few additional billions of dollars, the Post reports, by tapping the Treasury securities held by the Federal Financing Bank, which helps provide low-cost loans for federal programs. And Treasury could even sell off a portion of its $500 billion in gold reserves.
THE DIRECTIVE ordered agency officials to notify Treasury at least two days in advance of all “deposits and disbursements” between $50 million and $500 million. Payments above $500 million require five days notice, the memo said.
BOTTOM LINE: It’s becoming clear that a final deal — with both parties in agreement and all the details in place — is unlikely by June 1. A deal by June 8 or 9 is possible, but if there isn’t a deal, all eyes would be on the crucial date of June 15. It’s not out of the question that Treasury might get to the June 15 tax collection date without a default. And then there’s a huge tax haul coming in mid-September.
As this happy scenario gains momentum on Capitol Hill, the immediate impulse will be to leave town for Memorial Day and hope for the best — the need for immediate action may fade. But the huge differences on spending cuts will persist; this Treasury gambit would only postpone the day of reckoning.
Both parties recognize the implications for not raising the debt ceiling and House Speaker Kevin McCarthy said today “We’re not going to default” while also mentioning that the debt ceiling standoff is “not his fault”.
Our view is that we will continue to see this brinksmanship play out until the last possible minute, then both parties will agree to things neither is happy with, and we’ll move on.
What should investors do?
In a word, NOTHING. We consider this a short-term risk, and one that lasts only as long as it takes to get a deal done. The markets may show increased volatility, but moves to the upside and the downside should be quick and relatively short lived.
In taking a longer term view of your personal investments, you will find that based on past events deemed catastophic at the time (Brexit, Election results, Covid, The debt crisis in 2008, to name just a few) you’re still on track to achieve your goals.
If it helps to turn off the television or avoid the news, so be it. but extreme reactions to short term events rarely pay off, and usually make things worse.
Please feel free to call or email if you have specific questions and we’ll be happy to discuss further.
