Debt Ceiling Debate: Here’s What It Means for the Economy
May 15, 2023
By Michael List, CFP®
Investment Management Officer
One of the best pieces of parenting advice I received was, do not make empty threats to your children. The example given was “if you kids don’t stop fighting or I’ll turn this car around (3 hours into a two week vacation).” In addition to being ineffective at stopping the fight, it actually discredits other things you say to your children (so naturally, I decided never to take a family vacation: save money on lodging and I don’t have to hear them fight in the car).
The debt ceiling and potential government default are back in the news again. There has been much rhetoric, from both sides; about the negative consequences should the U.S. Treasury defaults on its debt, for future interest rates, the Dollar, and the stock market. Not surprisingly, this has caused anxiety for many people. On top of that, there has been a whirlwind of experts discussing related topics: debt ceiling, default, government shutdowns, 14th Amendment, sequestration, and furloughs.
We wanted to add some comfort and context to this debate. This week’s commentary will be a little longer than usual, so I will provide my conclusion in at the onset and follow with additional information. Perhaps most importantly — we (and the markets) do not believe U.S. Treasury default is a realistic possibility in June.
What the 14th Amendment Tells Us
Many have pointed to the fourth clause of the Fourteenth Amendment, as the primary reason the Treasury will not default on its debt and will prioritize debt service payments before other expenses. This clause states:
“The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.”
The clause is straightforward: “the validity of the public debt of the United States…shall not be questioned.” If we owe a debt, we pay the debt. Which brings us to the next question — do we have the money to pay the debt?
Can the Government Show Me the Money?
Cash flow is another major factor against default risk. While the Treasury hit the debt ceiling several weeks ago, they have been able to use extraordinary measures to fund all the outflow obligations. Treasury Secretary, Janet Yellen, noted around June 1 extraordinary measures will no longer be enough. At that time, revenue collected will not be able to cover all the expected outlays.
However, monthly revenue cash flow is approximately $370 billion, more than five times the amount required to service debt payments of $76 billion. The Treasury will collect more than enough cash to service the debts and be able to fulfill the clause in the Fourteenth Amendment. In addition to debt service, the monthly revenues could cover all monthly outlays for Social Security, Health and Human Services, and Military Programs. This does mean that other expected outlays will be missed (or most likely delayed), leading to a partial government shutdown.
History Provides Some Insight
In one sense, government shutdowns are uncommon, amounting to 87 days over the course of the past 45 years. In another sense, they have become more common as a budget-negotiating tool, as shutdowns have occurred during six of the last seven presidential administrations. Some of the shutdowns have lasted as briefly as a few hours to several weeks and have affected as little as one government agency to as many as every government agency.
During each of the shutdowns, some employees in the affected agencies were furloughed. This involved a temporary leave for employees, without pay. However, after the shutdown, the furloughed employees often received some back pay compensation. Each of the last three shutdowns resulted in several hundred thousand employees furloughed.
We can also look for clues at other debt-ceiling crises, which did not result in a shutdown. In the 2011 debt-ceiling crisis, after months of fighting, arguing and negotiating, the Government agreed on a resolution in the final days of extraordinary measures. Several days later, Standard & Poor’s credit rating agency downgraded the United States Government debt on notch for the first time in its history, from AAA to AA+.
While the rating downgrade made global media headlines, investors did not change their minds about the creditworthiness of the United States. Treasury prices were unaffected by the reduced credit rating announcement, and yields on the 10-Year Treasury actually declined by half of a percent in the months that followed.
Keeping Your Portfolio Safe From the Political (Empty) Threats
If we look at the market today, prices are slightly lower for Treasuries that mature in the first two weeks of June, indicating investors are concerned an agreement will not be finalized but not concerned about the risk of default. The price for bonds that mature the end of May versus the beginning of June is $99.60 and $99.56 (per $100), respectively. When investors are actually worried about a potential bond default, those bonds will sell for pennies on the dollar if they can be sold at all.
Statements from both sides of the aisle are clear, everyone is aware defaulting on public debt would have very bad consequences and each side wants to blame the other. Unfortunately, this strategy and threat have become more common in recent years.
While the Treasury market knows these are empty threats it can still have a ripple effect elsewhere. A delayed agreement could add volatility to the equity markets, reduce government spending and GDP in the current quarter and put credit rating agencies on notice. At this stage, we are not making any portfolio changes. Rebalancing last quarter had already positioned portfolios more defensively with better credit quality and a focus on valuation.
If you have questions for our investment team at SNB, please don’t hesitate to reach out to myself or any of our other team members. Your success matters to us.