Debt Ceiling Turmoil

As I write this article, the stalemate over the US debt ceiling continues. However, it is possible that by the time you read this, the debt ceiling predicament will have reached a resolution. Consequently, one might question the purpose of writing an article about a matter that is nearly concluded. Short answer—this is not the last time we will see a standoff over the debt ceiling. Since 1960, Congress has made 78 adjustments to the debt ceiling, 49 times under Republican presidents and 29 under Democratic presidents. Although not every ceiling adjustment has caused a showdown in Washington, these conflicts seem more frequent and become less amicable with each go-round.

Before diving into recent standoffs, one needs to understand what the debt ceiling actually is. In 1917, during World War I, the United States found itself in need of substantial funds to support the massive war effort abroad. To streamline the process, Congress introduced a new system that specified a maximum borrowing limit. This approach allows the federal government to borrow money to fund expenditures so long as the debt does not exceed that ceiling. If the debt limit is hit, the Treasury will run out of money. It is important to note that raising the debt ceiling does not authorize additional government spending; it allows for new debt to fund expenses that Congress has already approved.

The debt ceiling reminds me of a type of training that most runners or hikers will be familiar with: the “out-and-back.” The concept of an out-and-back is simple. You run a certain distance away from your starting point and then the same distance back to where you started. What does this have to do with the debt ceiling? Say I decided to go for a six-mile out-and-back run. From the Bragg office, I could take Morehead Street to the greenway and follow that to the southern tip of Freedom Park. At this point, I have run about three miles.

What if I decide I don’t feel like running three more miles to get back to the office? That isn’t really an option. I have already incurred the expense of the remaining three miles. Now is not the time to decide that I didn’t want to run six miles in the first place. I could, in an act of defiance, decide to throw my running shoes and my headphones into the nearby pond. After all, how can anyone run without shoes or music? This short outburst may provide a brief feeling of satisfaction, knowing that I tried to combat what ultimately lies ahead. But we all know that the three-mile accrued expense is still there. Perhaps I can come to some sort of agreement with myself to slow down for the last three miles, or I can decide to scale back the distance on my next run. Regardless of the deal I make with myself about the future, there is still the matter at hand: I need to fish out my shoes and headphones—hopefully before they take on too much water—and complete the six miles I initially committed to run. Depending on how long I dally around, I might get off easy and be able to reach my belongings with a stick. Or maybe I have to go for a swim…

The above scenario may seem absurd, irrational, and childish—not unlike some of the political theatre we have become accustomed to. The history of the debt ceiling is replete with standoffs and debates between the political parties. The most notable recent standoff occurred in 2011 when political wrangling over raising the debt ceiling resulted in the S&P credit rating agency downgrading the nation’s debt for the first time ever. The markets reacted negatively to these events. The dollar sold off, stocks plunged, credit spreads widened, and ironically, treasuries rallied. From its peak at the end of April 2011 to its trough in October 2011, the S&P 500 lost 19.4%. All of this, despite the fact that Congress struck a deal two days before the US exhausted its borrowing authority. Even with all of the turmoil in the US and Europe dealing with its own debt crisis, the market finished flat for the year.

We’ve discussed what the debt ceiling is and what a less-than-desirable outcome can look like, but why does this happen? What factors lead to a shoe-soaked, music-less slog back to the office? Earlier this year, Treasury Secretary Janet Yellen announced that we had officially reached the debt limit. This report led to Secretary Yellen using a maneuver known as “Extraordinary Measures.” Essentially, Extraordinary Measures allow the Treasury Department to prioritize payments, which could include suspending investments in civil servant benefit plans like the Postal Service Retiree Health Benefits Fund. The programs are then repaid once the limit is raised. These Extraordinary Measures provide a stopgap, which is projected to last until early June. The closer we get to the June deadline, the more likely we are to see increased volatility in the markets, like we did in 2011. The opposing political parties use the uncertainty to advance budgetary agendas.

If cooler heads do not prevail in Washington and we go past the early June deadline, the Treasury could still make interest payments to sidestep a technical default. We must emphasize that a US default has never happened before and if it does, difficult decisions will have to be made about who gets paid with the cash currently on hand. This uncertainty would affect programs like Social Security, salaries for federal civilian employees, and veterans’ benefits, among others. The situation would look very similar to a government shutdown, which we have experienced in the past.

If we reach the stage of an actual default—and again, this has never happened—there would be significant disruptions in global financial markets and widespread chaos. The stability of both domestic and international markets relies heavily on the economic and political stability of US debt instruments and the overall US economy. In such a scenario, interest rates would surge, and the demand for Treasury securities would plummet as investors lose confidence in their previously perceived safety. This could result in a reduction or complete cessation of investments in Treasury securities, further exacerbating the financial turmoil and uncertainty.

It is hard to imagine the US being hampered by an easily avoided self-inflicted wound. Failure to come to some resolution before we reach the debt limit is, in all likelihood, a low-probability event. But, if Congress does decide to go with the approach of throwing their running shoes into the Freedom Park Pond, it stands to reason they won’t let them sink to the bottom. We saw something like this happen in 2008 when Congress failed to pass the Troubled Asset Relief Program (TARP). The S&P lost 8.8% in one day. Members of Congress quickly got their act together and passed the bill days later.

What does all of this mean for your portfolio? As the deadline draws near, the market could experience increased volatility if our elected leaders cannot reach a deal. However, if they come to a resolution, the market might rally. Attempts to time the market often result in more pain than sticking to a long-term plan suited to your risk tolerance and goals. With that being said, if you would like to discuss how this might impact your portfolio specifically, please let us know.

Thank you for choosing Bragg to help you with your financial planning and investing.

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.