- On January 19th, Treasury Secretary Janet Yellen announced that the debt ceiling had been reached
- The good news is that the Treasury will be able to continue its mandated spending until June
- Over the years, this limit has been increased many times
- The current budget requires the Treasury to issue more debt in order to have enough money to spend what Congress mandated
- A true default could throw financial markets into chaos. That being said, we can say there are three scenarios that are much more likely than any other
On January 19th, Treasury Secretary Janet Yellen announced that the debt ceiling had been reached. The good news is that the Treasury will be able to continue its mandated spending until June. Beyond that, it's unclear what might happen. However, it's important to note that the US has a successful history of raising the debt ceiling in similar situations.
Here are our thoughts on how this may play out and its potential effect on markets.
What is the debt ceiling?
The debt ceiling grew out of a time when Congress had to approve every Treasury bond issue. During World War I, Congress decided that this system was impractical. Imagine if you had to call your bank for approval before every purchase—that’s what it was like. To streamline the process, a law was passed instead passing a law that gave the Treasury blanket permission to manage the US debt as it sees fit – so long as the total debt didn’t breach a certain limit. This was the first iteration of what we now call the debt ceiling.
It has evolved over the years, but the basic concept is the same: Congress passes a budget that tells the Treasury how much to spend and separately passes a debt ceiling that authorizes the Treasury to sell bonds to fund the spending.
Over the years, this limit has been increased many times. According to the Treasury Department, Congress has increased the debt ceiling in some form 78 times since 1960.
What would happen if Congress doesn’t increase the debt ceiling?
When Congress passes a budget, the Treasury is obligated to spend money in accordance with that budget. The current budget requires the Treasury to issue more debt in order to have enough money to spend what Congress mandated. There is no legal precedent for what the Treasury should do in a case where it cannot follow Congress’ instructions.
In effect, the Treasury would have to break the law by ignoring the budget or by ignoring the debt ceiling.
What would the Treasury do in this situation?
Various legal analysts have different views on what is possible if the debt ceiling is truly breached. One idea is that the Treasury could prioritize payments. For example, there is a proposal in the Senate to require the Treasury to make payments on Treasury bonds, social security, and other programs even in the event that the debt ceiling is reached.
Others argue the 14th Amendment to the Constitution requires the Treasury to prioritize payments to bondholders even without formal action from Congress. While this amendment is primarily about equal rights, it includes a provision that says the US's debts “shall not be questioned” and that because of this, the debt ceiling is actually unconstitutional.
There are other even more creative ideas, including the "trillion dollar coin," which involves using the Treasury's power to create commemorative coins as an end-around of the debt ceiling.
What would it mean for the Treasury to “default?”
A bond default is simply a term for not making full and timely payment on any piece of debt, including interest or principal (the amount originally borrowed). Treasury bonds are very much the backbone of the entire global financial system. They are used around the globe as the safest of assets. This includes everything from banks using them as collateral to whole nations using Treasuries as foreign currency reserves. A true default could throw financial markets into chaos.
Exactly how such a situation would play out is extremely hard to guess. Defaulted bonds are not suddenly worthless; rather, they are valued based on expected future payments. For example, one plausible scenario would be for Congress to miss the deadline to avoid a default, but perhaps under pressure from volatile markets, they come to some agreement a few days later. Markets would probably sense this as a likely scenario and not change the value of Treasury bonds very much.
We saw a version of this in 2011, which was the closest Congress has come to not raising the debt ceiling in a timely manner. Standard and Poor's lowered the credit rating of the US from its highest rating of AAA to AA+, which it remains at today. Surrounding this period was substantial volatility, with the S&P 500 falling 16% from July 22nd to August 8th of that year before rebounding in October. However, Treasury bond prices rose during this period as global investors fled to safety, still viewing Treasuries as the safest asset.
How is this likely to play out?
At Facet, we are not political analysts. In fact, we would argue that, at times, politics is much harder to predict than markets are. That being said, we can say there are three scenarios that are much more likely than any other.
- After a period of tense negotiations, some kind of compromise is reached, and the debt ceiling is raised before the deadline.
- The deadline does pass, but a deal is brokered a few days afterward.
- The deadline passes, but the Treasury prioritizes payments in such a way that there is no bond default.
We should note that the 2011 period may weigh heavily on the minds of the current leaders. The politicking at that time was highly unpopular and was probably part of the reason why Republicans lost seats in the 2012 election.
What would the Federal Reserve do?
In his press conference after the February Fed meeting, Chair Jerome Powell was asked about the debt ceiling. Not surprisingly, Powell said that it was "Congress' job" to deal with the debt ceiling and those negotiations "don't involve us." The Fed generally wants to remain as apolitical as possible, preferring to stay out of the debt ceiling debate.
However, we know from transcripts during the 2011 crisis that the Fed did discuss what role they might play in the event of a default. The Fed was under different leadership at that time, and in addition—since a default didn't actually occur—none of the proposals became official. However, one thing is clear from reading the transcript of the Fed’s August 1st emergency meeting, just before a default would have occurred: the Fed wasn't going to allow a debt default to turn into a banking crisis.
Brian Sack and William English, who together ran the markets desk for the Fed at the time, wrote a memo outlining their recommended actions. Key among these was that the Fed would treat defaulted Treasury bonds the same as they had before the default. That is to say that banks could use these bonds as collateral in transacting with the Fed. This would allow banks to get cash from the Fed while they were waiting for the Treasury to make good on those bond payments.
We think the Fed would act similarly today. As Powell said in his presser, making budget decisions isn’t the Fed’s job. However, ensuring that markets function normally and that banks have access to liquidity is a core part of the Fed’s mandate. They would undoubtedly continue to serve this function in the event the debt ceiling crisis became acute.
One thing the Fed did not want to do was be seen as “effectively financing government spending.” In effect, this rules out ideas like the Fed making payments on Treasury bonds themselves with newly printed money. Congress will have to actually act to raise the debt ceiling to avoid a default. The Fed will merely act to limit any damage to the banking system.
What should we do with our investments?
In theory, a debt default would be a highly impactful event in markets, but it is a classic example of an investment trap. By this, we mean making any kind of bet on Congress failing to raise the debt ceiling is very likely to be a losing bet.
Consider the following possibilities:
- Stocks could rise between now and the June deadline, and any debt ceiling-related selloff might not be enough to erase these gains.
- A default could happen, but Congress raises the debt ceiling a few days later, resulting in a sudden jump higher in markets, leaving you no time to buy back in.
- Markets could anticipate a last-minute deal, and therefore stocks never actually sell off materially despite continued political maneuvering.
In other words, while there are many possibilities for how the debt ceiling fight will play out, most of them involve some kind of immediate resolution. This means that making any kind of portfolio action would require very precise timing, which we believe greatly lowers the odds of such a trade being successful.
To be successful, you would have to get three things right:
- The outcome that occurs,
- The precise time to buy, and
- The exact time to sell.
Obviously, getting one of these right is hard enough, let alone all three.
We believe the wisest investment decisions are based on economic and financial events, even with potential volatility associated with upcoming debt ceiling deadlines. Although these moments may be amplified in media reports to create a heightened sense of dramatic tension, we choose instead to remain focused on long-term factors – persevere through short-term fluctuations for an optimal outcome.