Government Debt Ceiling Deja Vu
Debt ceiling talks and ramifications for investors and the U.S. government are the top news stories of the day. Bond and stock markets have been volatile as the June 1st date deadline (when the government runs out of money) quickly approaches. While the S&P 500 is down only about 1.7% since its recent high on February 2nd, we see significant volatility in the bond markets, as measured by the MOVE index, which recently reached its highest level since 2009.
Should We Be Concerned?
Yes! If Congress fails to raise the debt ceiling, the U.S. will face significant negative consequences, including U.S. Treasury bond default, higher interest rates, and possible economic catastrophe. However, this is unlikely to happen, in my opinion. No matter how much political posturing there is, neither political party is interested in allowing the U.S. economy to suffer the negative consequences of default. Even so, we may need to wait until June 1st before a resolution and compromise are reached — similar to 2011 when Congress raised the debt ceiling just two days before the U.S. Treasury ran “out of cash”.
What Is the Debt Ceiling?
The debt ceiling is the statutory maximum of money the U.S. Treasury is allowed to borrow by issuing debt in the form of Treasury bonds. Note, the amount raised through this process is used to pay existing obligations already approved and appropriated by Congress through the budget process.
The federal government operates on a revenue deficit every year (not enough revenue collected to pay all the expenses), and the government issues debt to fill the gap. The current debt limit is $31.4 trillion and was reached on January 19, 2023. If Congress fails to raise the debt ceiling by June 1st, the government will need to delay payments on future obligations and possibly default on its debt payments (ie: Treasury bonds).
What Are the Implications?
As we are witnessing now, the risk of default leads to increased volatility in the stock and bond markets and may potentially result in a downgrade of U.S. Treasury bonds. Treasury bonds currently hold the highest rating from Fitch and Moody's, and the second highest rating from Standard & Poor's.
In 2011, Standard & Poor’s was the one agency that downgraded U.S. government bonds to the current AA+ rating from its highest rating of AAA. Despite this downgrade and the period of uncertainty, the bond market actually held up and gained in value, whereas the S&P declined before starting its longer-term climb in August 2012.
Note: lower bond yields mean higher bond prices
Is possible that this time is different, and the government will, indeed, default on its debt? Yes, but history shows there is always another "crisis" on the horizon, so investors do better to focus on the long-term and not react to short term volatility. Declines in your portfolio are likely to be temporary.
Pamela Chen is the Founder and Chief Investment Officer of Refresh Investments LLC, a fee-only financial planning and investment management firm with offices in Santa Monica and San Diego, CA serving clients throughout Southern California and the United States.
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