The Current Situation:
The United States federal debt limit has become a topic of concern as the country nears a critical deadline on June 1. Investors are apprehensive about the possibility of Washington’s failure to reach an agreement, which both sides acknowledge would be a self-inflicted disaster. While it remains unclear how the situation will unfold in the coming weeks, the good news is that financial markets are mainly taking these events in stride. But how can investors maintain the proper perspective around political and fiscal uncertainty?
Understanding the Debt Limit:
First and foremost, it’s essential to comprehend what the debt limit entails and what it does not. In simple terms, the federal government borrows money to pay its bills by issuing Treasury securities since government spending often exceeds government revenues, primarily tax revenues. This borrowing increases the national debt, which reached the debt ceiling of $31.4 trillion in January. As a result, the Treasury Department has been utilizing “extraordinary measures” to prevent the country from defaulting on its obligations.
The debt ceiling functions as a mechanism that necessitates Congress’s approval of additional borrowing beyond these levels. As a result, the discussion surrounding the debt ceiling often needs to be clarified, as it is not directly linked to government spending. The Congressional process for authorizing a budget by September 30 each year is distinct from whether the Treasury can pay its bills.
Controversy Around the National Debt:
Secondly, the ever-increasing national debt is a controversial topic that affects the economy and markets in various ways. Currently, the Democrats, who control the White House and Senate, and the Republicans, who control the House of Representatives, are in a deadlock. On April 26, the House passed a debt limit bill by a slim vote margin of 217 to 215. The bill would raise the debt limit through March 31, 2024, or until the national debt increases by another $1.5 trillion. However, it also includes provisions such as discretionary spending limits, the repeal of renewable energy tax credits, and increased work requirements for benefits programs. The bill is politically fraught and is thus unlikely to pass the Senate and be signed into law.
Historical Debt Ceiling Standoffs:
As is typical, there is a great deal of political posturing around this issue, with each side trying to gain the upper hand. Similar debt ceiling standoffs have occurred over the past decade, with the limit being suspended and raised in 2013, 2014, 2015, 2017, 2018, 2019, and 2021. According to the Congressional Research Service, the debt ceiling has been raised 102 times since World War II.
Impact on the Markets:
Despite the headlines and investor concerns, these events have had little long-term impact on the markets. The United States has never defaulted on its debt. Most economists and policymakers agree that doing so would lead to financial market turmoil and increase borrowing costs for businesses and individuals. The bond market reflects this risk, with a significant increase in Treasury rates with maturities around the debt ceiling deadline and much lower rates after that.
In 2011, however, markets did not remain relatively calm during a similar standoff. Standard & Poor’s, a credit rating agency, downgraded the U.S. debt. The stock market fell into correction territory, with the S&P 500 declining by 19%. Ironically, the prices of Treasury securities increased during the 2011 debt ceiling crisis. Even though these were the exact securities being downgraded, investors still believed they were the world’s safest during heightened uncertainty. The debt ceiling was eventually raised, and a new budget was approved, allowing the markets to rebound.
Lastly, while higher tax rates are not guaranteed, the national debt’s current level implies that the odds of increased tax rates may rise. Investors must distinguish between their political preferences and how they manage their investments.