On Monday, Treasury Secretary Janet Yellen stated that the US government may be unable to pay its bills in June if Congress does not act to raise the federal debt limit. While they may be able to stretch things to July, the point is that the limit will be hit soon and something needs to be done to prevent an unprecedented breach of confidence in the US government.
What are the consequences of not raising the debt ceiling?
In recent years, there have been several government shutdowns that have come and gone with seemingly little impact. These occur when Congress fails to pass a budget to fund annual appropriations and this shuts down services deemed non-essential such as National Parks, EPA/FDA inspections, and Social Security Card issuance. Essential services and mandatory spending not subject to annual appropriations continue uninterrupted, so while inconvenient for some, these shutdowns are usually over fairly quickly and leave no permanent consequences.
The debt ceiling is different. If Congress does not act, the US government will not be able to legally pay key expenditures such as Social Security and Medicare benefits, military salaries, tax refunds, and national debt payments.1 While all of these items are critical such that even a delay would cause major issues, it is the payments on Treasury bills and notes that most worry global financial markets because any delay on these payments constitutes a default.
The US government has never defaulted on its debt payments. Because of this, US Treasuries are considered to be a near risk-free financial asset and thus set the floor for interest rates denominated in US dollars. If Treasury buyers can no longer be 100% confident that the US government will not default, we believe that investors will demand compensation in the form of higher interest rates, and ratings agencies will downgrade the United States’ credit rating. This should raise future borrowing costs not only for the US government, but for all debtors, assuming that Treasuries would still set the interest rate floor.2 We have seen over the past year how higher interest rates have caused myriad issues throughout the economy, most notably the recent regional bank failures. Coupled with the suspension of government payments and shock to confidence, the impact would greatly increase the probability of a severe recession.
What happened in the debt ceiling crisis of 2011?
The S&P 500 fell over 15% from July 26, 2011 to August 8, 2011. This period included the dramatic debt ceiling showdown and last minute Budget Control Act of 2011, which was agreed to on July 31, 2011, two days before the borrowing authority of the country would have been exhausted. It also included S&P downgrading the United States from AAA to AA+ on August 5, 2011 (it is still at AA+). This was also the time of the Euro currency crisis, when Greek 10-year debt yields were 15%+ and Portugal/Spain/Italy debt yields were also very elevated, so it is not true that the full 15%+ drop can be ascribed to the debt ceiling crisis and US credit downgrade, but they did contribute significantly. To be clear, Speaker Boehner and President Obama were able to reach a deal before any payments were missed. If the United States would have defaulted, we believe the market drop would have been greater.
What are the implications for client portfolios?
This is a macro risk that we will be watching closely over the next several weeks. However, because this risk is manmade and fixable with the stroke of a pen, we are not overly concerned at this point.3 We are very confident that a deal (or at least a short-term “kick the can” fix) will eventually be reached, but there are two big questions: (1) Will they wait until the last minute like in 2011? In this plausible case, we would expect a moderate and temporary market sell-off similar to the one seen in 2011. (2) Will they go past the deadline and actually let Treasuries go into technical default? In this more extreme and unlikely outcome, we would expect a swift and dramatic market sell-off that would likely cause a change of heart for those refusing to come to an agreement.4
Bottom Line
As long-term investors, we do not recommend making any portfolio changes for this potential temporary issue. Market risks like the debt ceiling are why you get paid a premium over the long run to own equities instead of cash or bonds. They are also the reason why it is so important to invest at a target risk level that you are comfortable sticking with in both good times and bad. Historically, it has been a costly mistake for a long-term investor to sell equities after the stock market has already dropped significantly. If the unlikely worst-case debt ceiling scenario does unfold, we believe this statement would be equally true once again as the economy and stock market adapt and recover.
Footnotes
1 https://home.treasury.gov/policy-issues/financial-markets-financial-institutions-and-fiscal-service/debt-limit
2 Government interest rates may actually go lower initially in this worst-case debt ceiling scenario as the Federal Reserve cuts interest rates because a severe recession is now more likely.
3 There is also talk of the government using tactics of questionable legality to circumvent the debt ceiling altogether and thus avoid having to reach an agreement, but we believe the market would view this path (that would likely end in a dramatic Supreme Court ruling) very negatively as well.
4 On September 29, 2008, the government’s $700 billion financial bailout plan, the Troubled Asset Relief Program (TARP), was rejected by the US House of Representatives, causing the S&P 500 to fall over 7% that day. TARP was signed into law by President Bush on October 3, 2008.