Undoubtedly you’ve seen numerous stories in the media recently about the national debt and the debt ceiling. The short story is the US debt limit will need to be raised by Congress to fund the federal government’s spending obligations. If an agreement is not reached in a timely manner, perhaps by early June, it’s unlikely, but possible that a technical default could take place on some US debt. It’s important to note that hitting the debt ceiling would not mean all government functions would come to a halt. Instead, because the US government spends more than it receives in tax revenues each year, it would not be able to spend more money than it takes in. Once reaching that threshold, the government would need to prioritize which outlays are deemed essential and may cut lower-priority financial obligations until a new funding deal is agreed to and enacted.
What is the debt ceiling?
The debt ceiling was first established in 1917, mandating Congressional approval for additional debt issuance once the predetermined limit was reached. Until fairly recently, it was viewed as a relatively routine legislative measure. Since World War II, the ceiling has been raised or temporarily suspended on 102 occasions, with 78 instances occurring since 1960. However as the size of our national debt has grown over the past 20 years, the issue has become more and more political, as legislators have used the debt limit as a bargaining tool to reduce spending; much like a high stakes game of Chicken.
Has something like this ever happened before and how did markets react?
Yes. Although the US has never defaulted on its debt, there were two instances of partial government shutdowns in 2013 and 2018–19, which were directly tied to the debt ceiling. Surprisingly during both episodes, the market responded without significant volatility.[1]
In 2011, Congress raised the debt ceiling two days before the Treasury was projected to reach its limit. Shortly after this event, Standard & Poor’s downgraded the U.S. credit rating from AAA to AA+. Treasury bonds initially experienced a sell-off in response to the news, as expected. However, counterintuitively, market participants subsequently sought the safety of U.S. government bonds, resulting in a rally for Treasury bonds.[2]
What’s our outlook going forward?
While it can be comforting to gauge how markets weathered these past events, we would still consider it likely that market volatility will increase the closer the government gets to the debt ceiling without a deal, particularly in this politically partisan environment. It is our belief that ultimately markets will be able to weather this storm and that an agreement will eventually be reached.
Despite the possibility of uncomfortable volatility ahead, we maintain our belief in staying invested, focusing on long-term investment objectives, and avoid timing the markets. Historically markets are forward looking in nature, and once negative news is factored into market prices, they frequently exhibit unexpected rallies well in advance of fundamental improvements.
If you wish to discuss these events further, please contact Nick Berlen to schedule a meeting with a member of Napier Financial Team. (nberlen@napierfinancial.com; (781) 884-2355).
[1] Source: Bloomberg and ICE Data Indices. Data as of May 16, 2023. 10-Year U.S. Treasuries = Bloomberg 10-Year U.S.> Treasury Index. U.S. High Yield
Bonds = ICE BofA U.S. High Yield Constrained Index. U.S. Corporate Bonds = ICE BofA U.S. Corporate Bond Index.
[2] Source: Bloomberg and ICE Data Indices. Data as of May 16, 2023. 10-Year U.S. Treasuries = Bloomberg 10-Year U.S.> Treasury Index. U.S. High Yield
Bonds = ICE BofA U.S. High Yield Constrained Index. U.S. Corporate Bonds = ICE BofA U.S. Corporate Bond Index.
