Someone always likes to claim that something will be the end of the world. The latest apocalyptic prediction is the debt ceiling debates. These prophets say that reaching the debt ceiling will cause stocks, bonds, the economy, and more to be devastated.
This isn’t the first time these predictions have been made about this type of crisis. The debt ceiling has been raised over 70 times and is often raised at the last minute. This means that, while there can be a lot of uncertainty, the conclusion is normally anticlimactic.
But what will happen if we do reach it?
For stocks, reaching the debt ceiling could mean that the stock market goes down as investors flee to cash, that the stock market goes up as investors flee from from US Treasuries or as inflation pulls prices higher, that the stock market stays the same as nothing or both of those events happen, or that different parts of the stock market behave differently.
In my family, we would reply to that paragraph with, “Yep. Up, down, flat, or a mixture. Those are the options.” All is just speculation.
Investors assume that they know how the market will react to a possibility. They also assume that if you only knew what would happen you could predict how to invest. Both of these are false. We don’t know what will happen, and when investors can know what will happen, the efficient market prices that possibility in rapidly.
The pressing question of most investors is: Will the federal government default on its debt? In my opinion, the executive branch would have to try to default for that to happen.
Reaching the debt ceiling means the executive branch can’t add to our debt. It is like a family mired in credit card debt who has reached a $10,000 credit limit. The family is not allowed to charge more on the card, but they can still spend money from income and are still obligated to pay the interest on their debt. It isn’t necessarily a catastrophe but is forced austerity.
In all of 2022, net interest on the debt was $475B or 8% of U.S. Government Spending. Meanwhile for fiscal year to date as of April 30, 2023, the federal government has collected $2.69T in revenue so far. This means that only 17.67% of the revenue collected so far needs to be used to pay off ALL of our interest on the debt from last year.
Worrying about the government defaulting on their debt is a bit like worrying if you can pay your mortgage when you’ve hit your credit limit. If you are motivated to pay your mortgage, you can do it from your income alone and make cuts elsewhere.
While we think it is unlikely that the U.S. government will default on its debt, some Treasury bonds currently feature a yield premium, suggesting that the market has priced in the potential risk. Similarly, we believe that the equities market prices reflect debt ceiling uncertainty, giving the potential for a slight advantage to investors who are willing to take the risk.
But what about Social Security and Medicare? Those represented $1.22T and $755B respectively in 2022 for a total of $1.975T and, in my opinion, are more at risk of default than Treasury bonds. But would the Treasury really default on Social Security? They’ve never been faced with that decision before.
The Treasury could just ignore the debt limit and add to the metaphorical credit card. Who would stop them? The only barrier to that excess debt is if someone wanted to sue the U.S. Treasury department for violating the then-standing Congressional debt limit. On the flip-side, if they don’t spend what they promised, those to whom the assets are due could sue the U.S. Treasury for failure to satisfy their obligations. Which is the smaller problem? They’d have to decide.
And would Congress even let them get to that point? Congress didn’t in 2021, even though they were similarly gridlocked.
Two years ago, the federal government reached the debt limit on August 1, 2021, and October 18, 2021 was identified as the date they run out of extraordinary measures. On October 6, 2021, the White House released a letter titled “The Debt Ceiling: An Explainer .” They explained the Treasury’s plan to use “extraordinary measures” (mostly summarized as stopping inter-governmental spending) to suppress spending, suspend new investments in U.S. Treasuries or redeeming existing investments, and exhaust its cash stores while they wait for Congress. If that runs outs, then the plan is to use incoming revenue to cover expenditures while making cuts to spending. They estimate that this would cover approximately 80% of their spending but that default was possible. In 2021, the first legislation calling for a debt ceiling increase was signed into law on October 14, 2021 , extending the cut-off date into December 2021. Then, on December 16, 2021 the new debt limit was added actually solving the immediate problem.
And just like that, the debt ceiling crisis was solved. It’s anticlimactic.
Building an underground safe room stocked with food may help in the event that the above world is made uninhabitable, but the unlikely benefit does not offset the certain cost. Similarly, the certain cost of selling all your securities and flat-lining to cash is not offset by the unlikely benefit that your dire predictions are right.
What can we do?
It is Congress’s job to manage our debt and not hit the debt ceiling. We can’t help with that. Hitting the debt ceiling is a known and easily avoidable issue, even if both sides hate each other. Take 2021 as an example. While in heated debate, they passed an October legislation to kick the can another two months so they could continue to debate. The debt debate is a debate worth having, although the congressional timing is poor. Ideally, our politicians would be willing to have this important debate when there isn’t a pressing timeline. Alas, even our congressmen are in a lifelong battle against procrastination and laziness.
If the debt ceiling is reached, our plan is to rebalance.
If the debt ceiling is not reached, our plan is to rebalance.
We design our asset allocations to weather all kinds of market volatility, which is why rebalancing is our plan in the face of hopes, fears, or uncertainties.
If you’d like to read more about this topic, the following articles may be of interest:
- “The Lower The Market Falls The More Important It Is To Stay Invested“
- “Markets are Down? Time to Rebalance!“
- “13 Financial Actions to Consider During Market Downturns Like This“
- “Stay Invested After Volatile Quarters“
Photo by Rainier Ridao on Unsplash. Image has been cropped.