The Debt Ceiling - What it is and why it (might) matter

May 11, 2023

Dear Clients and Friends,

If you pay attention to the financial press, you are likely aware of the “debt ceiling” debate going on in Washington and the potential for this political game of chicken to disrupt financial markets. Moreover, if the United States does indeed default on its debt obligations, which is a possible albeit low-probability outcome of the debate, it would have dire long-term consequences for both the US and global economy.

Some debts are fun when you are acquiring them,
But none are fun when you set about retiring them.

Should investors be worried? Well, yes, to a degree. We don’t mean to be vague, but we hope to have a more determinate answer after this week’s meetings between President Biden and members of Congress, in which they will hopefully reach a quick and benign agreement to lift the debt ceiling, thereby allowing the country to continue paying its bills. While a speedy resolution would render the debt ceiling argument as much ado about nothing, we note that neither side has yet shown a willingness to budge from their starting positions. As such, consider this a “work in progress” and subject to change with the news coming from the Capitol and White House.

What should investors do? While we acknowledge that financial market volatility will surely escalate if the debt ceiling negotiations drag on, the best course of action in uncertain times has historically been to “stay the course” while preparing for short-term cash needs in advance. As Ross Loomis, our Director of Research, summarizes:

“Because we think there is only a small chance of a debt ceiling breach, we do not recommend repositioning portfolios in expectation of market turmoil. We do recommend planning for how you might respond to such turmoil, which (ideally) would be to remain invested and not need to sell anything unexpectedly impacted by a debt ceiling breach, such as a money market fund.

Markets do not appear to be pricing in any significant impacts of the current debt ceiling impasse, so if you have any concerns, please contact your Evermay advisor and discuss potential options for your portfolios.”

With that advice in mind, at Evermay we have proactively reduced client exposure to the US Treasury bonds maturing this June, which is the soonest the Treasury’s coffers might be emptied, according to Treasury Secretary Janet Yellen.[1] Though we view a default as unlikely, and would expect the US government to ultimately make good on its obligations, we’d rather avoid the potential inconvenience of not having that money available when it is needed, whether to meet clients’ cash needs or reinvest in longer-dated bonds. If a resolution isn’t achieved by June, we’ll review the July and August Treasury bond holdings as well.

What’s the debt ceiling, anyway?

In a nutshell, Congress votes to set a limit on how much money the US Treasury is allowed to borrow to pay for the things the government has already committed to spend money on, which includes everything from national defense to funding Medicare and Social Security to paying off prior borrowings such as those June bonds we mentioned above. If the Treasury has borrowed up to the ceiling limit but needs additional funds to pay the government’s bills, Congress must then vote to suspend or further raise the Treasury’s borrowing limit.

What many don’t realize is the debt limit has already been reached – in fact, that happened back in January of this year. Treasury Secretary Yellen has given Congress some financial flexibility by moving money from pocket-to-pocket and tapping unused cash to make necessary payments. This flexibility is what is expected to run out as soon as June, though it could extend as far as August.

So what?

If the debt ceiling is not raised, Treasury can spend only what it takes in as current revenues, primarily from taxes. As the US borrows about 22 cents for every dollar spent, or around $1.4 trillion of last year’s $6.3 trillion budget,[2] an inability to borrow additional funds would imply shutdowns and disruption of government services. This doesn’t mean the government wouldn’t pay its debts, though, but it would be up to the Treasury Department to prioritize the order of payments.

Even without a default, such a scenario would have negative consequences, as Ross notes: “If the US Treasury were to continue US debt payments but fail to meet other payment obligations, the people and organizations relying on those payments would be expected to reduce their own spending. Those facing credit constraints may have severe consequences that would spillover negatively into the broader economy. We would expect financial markets to still be affected in this scenario, as concerns over the macroeconomic consequences and risks of potential impact to Treasury markets become greater.”

We believe a debt ceiling agreement is highly likely, even if at the last hour. The question is, will it arrive with or without collateral damage? In comparing 2011’s debt limit debate to a game of Russian roulette, Berkshire Hathaway’s Warren Buffett said, “We don’t need to tell the rest of the world that anytime people in Congress start throwing a tantrum that we’re not going to pay our bills.”

I don’t make jokes. I just watch the government and report the facts.

We want to underscore the point that the debt ceiling discussion is, for now, one of politics, not economics. Unfortunately, there’s no way to predict the ultimate impact, if any, on the US bond market, the US stock market, or the global financial markets, but we will be watching vigilantly for further developments on this front.

Mitch Schlesinger
Chief Investment Strategist