4 min read
The Debt Ceiling Impasse
David Hagee Senior Vice President, Chief Investment Officer : May 25, 2023 7:00:00 AM
Along with being the primary source for financing the U.S. government, the $24 trillion U.S. Treasury market is the largest debt market in the world. For the U.S. to finance its budgeted spending obligations, Congress must approve the issuance of new Treasury bonds, and holds responsibility for setting the limit on the amount of national debt that the federal government can incur. This limit, or debt ceiling, is determined after negotiations between the executive and legislative branches of the government. Throughout its 234-year history, the U.S. has never defaulted on its debt obligations.
Since 1960, Congress has raised, extended or redefined the U.S. debt ceiling 78 times under both Republican and Democratic presidents. 1 However, debt ceiling negotiations have become an area of contention over fiscal policy in recent years, leading to the current stalemate between the Biden White House and the Republican-controlled House of Representatives.
Currently, the U.S. debt ceiling is $31.4 trillion, which equates to 117% of the U.S. gross domestic product. Of this debt, roughly $26 trillion is held by the public or foreign entities and nearly $5.2 trillion of U.S. Treasury securities held by the Federal Reserve.
For the 2022 fiscal year, the U.S. federal budget was $6.2 trillion in outlays, with only $4.9 trillion in revenues. That left a $1.4 trillion deficit, which was financed through borrowing – that’s roughly 25% of the budget financed by deficit spending. 2
What happens if the U.S. were to default?
Talks between White House officials and House Republicans have ricocheted between progress and deadlock for weeks. The two sides currently are at loggerheads over the amounts and timeframes of discretionary spending caps, the terms of fast-tracking energy programs and expanded work requirements for beneficiaries of food stamps and cash assistance programs. 3 Meanwhile, the countdown to a possible funding crisis is on.
Treasury Secretary Janet Yellen has stated her department will no longer be able to meet its debt obligations in early June. Private firms forecast a slightly longer grace period, stating the U.S. can make it to the estimated June 15 tax deadline, which could provide the government funding into the July/August time frame. In addition, the Treasury Department is empowered with extraordinary measures to stretch things out longer. These protocols include making sure that Treasury bills are recycled, and restrictions on spending, making available only mandatory spending and suspending discretionary expenditures.
Based off the combination of our strong domestic economy, the global dominance of the U.S. dollar and the taxation ability of the government, the U.S. has stellar credit ratings and generally is considered to the best borrower on the planet. A U.S. government default would likely result with a credit downgrade by a ratings agency.
This has happened before in 2011 when a similar debt limit squabble led S&P Global Ratings to downgrade the U.S. credit rating from AAA to AA+, a rating we have maintained for 12 years. 4 The dip in credit rating sent a shockwave across the markets, pushing stock and bond prices lower while driving up future borrowing costs.
How could this play out?
Negotiations between representatives of President Joe Biden and House Speaker Kevin McCarthy have whipsawed as the June 1 line in the sand has drawn nearer. Commerce Trust believes the two sides will acquiesce to a deal and avoid a default even if it’s deep in the eleventh hour.
Should talks completely break down, Biden could opt to invoke section 4 of the 14th amendment, which states the validity of America's public debt shall not be questioned. This would allow the president to raise the debt limit without an act of Congress. Given the high stakes nature of this option — the appearance of an executive branch power grab that would almost certainly be contested in the courts — we see this as the least likely course of action.
Impact to the markets
As previously stated, we are not in uncharted territory. During the 2011 debt ceiling faceoff, the S&P 500 Index dropped 17% over a two-week period. 5 A default would likely trigger much more severe conditions.
How bad? Moody’s Analytics projects the U.S. economy would contract by nearly 1% immediately following a default. Also, the unemployment rate would jump to 5% from the current 3.4% rate, which equates to nearly 1.5 million Americans losing their jobs. 6 If the economic drag of a default wasn’t bad enough, the damage to America’s reputation as the leading global financier could be irreparable.
Another consideration: the U.S. government is on the hook for $13.6 billion in interest payments spread out over 11 dates in the month of June. That creates a scenario where there are multiple opportunities for the government to miss a payment over the course of the next month without a new debt ceiling agreement in place. 7
From a portfolio management perspective, Commerce Trust anticipates market volatility will remain as the debt ceiling drama plays out. On the bond side, we have seen a mad scramble to buy Treasury bills — still the world’s safest asset — ahead of the June deadline. Over the past 12 months, the cost to insure 5-year Treasuries against default has quadrupled, an indication of the lack of liquidity in the markets.
1 U.S. Treasury Department
2 The Congressional Budget Office
3 Akayla Gardener, Jarrell Dillard and Billy House, “Biden-McCarthy Debt Talk Ends in Optimism, but Without a Deal,” Bloomberg, May 22, 2023.
4 Damian Paletta and Matt Phillips, “S&P Strips U.S. of Top Credit Rating,” Wall Street Journal, August 6, 2011.
5,7 Joe Rennison, “What Would Happen if the U.S. Defaulted on Its Debt,” New York Times, May 18, 2023.
6 What Happens if America Defaults on Its Debt,” The Economist, May 23, 2023.
Past performance is no guarantee of future results, and the opinions and other information in the commentary are as of May 23, 2023. This summary is intended to provide general information only and is reflective of the opinions of Commerce Trust. This material is not a recommendation of any particular security, is not based on any particular financial situation or need and is not intended to replace the advice of a qualified attorney, tax advisor or investment professional.
Diversification does not guarantee a profit or protect against all risk. Commerce Trust does not provide tax advice or legal advice to customers. Consult a tax specialist regarding tax implications related to any product and specific financial situation. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Commerce Trust is a division of Commerce Bank.
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