Investment Committee on the Debt Ceiling

[Jw2]

Looming somewhere just on the other side of Memorial Day weekend is the potential for the US government to begin to fall short of funds needed to meet obligations. Treasury Secretary Yellen said this week that the US is highly likely to default in early June if Congress fails to lift or suspend the legal limit for government borrowing.

Because the economy and the financial system are largely dependent on the concept that the federal government is good for what it owes, a potential breakdown here is stoking a fair amount of fear. We do not wish to downplay the potential risk but, remain cautiously optimistic. In our view, very few people should consider any direct action at this time, and investors should not alter long-term, strategic allocations. We do not envision direct impact on the ability for markets to function or for access to funds at financial institutions.

Will the Government default?

Republicans are seeking spending cuts in exchange for raising the ceiling, while the White House and congressional Democrats are seeking to do so without conditions. President Biden had previously said he would not negotiate on the topic but has begun hinting at concessions including potentially a stable budget. Talks have increased in intensity in recent days, but as of this writing the two sides still say they are relatively far apart. It is widely believed that a group of more extreme Republicans will likely oppose any compromise, meaning Speaker McCarthy will need to gain support of some Democrats.

Like most, our view is that default remains unlikely but is possible. According to the Department of the Treasury, the government has raised the debt ceiling 78 times since 1960. Most of those were well in advance, some came closer to the edge. Most likely the ceiling will again be raised just in time, but it is far from certain.

With a deeply divided congress and a highly polarized feel in Washington, this is not a routine increase. However, politicians are mostly interested in getting re-elected. Crashing the economy or being perceived as stopping a resolution may be popular among fringe constituencies, but not most voters. If you are Joe Biden or Kevin McCarthy or Charles Schumer or anyone associated with the negotiation process, getting as much of your agenda as possible is natural but a market or economic crash is not in your best interest. It can be easy to be skeptical, but we believe most elected officials want what they believe is in the best interest of the country. With very few exceptions, no one is suggesting a default or prolonged government shutdown is desirable. If the economy starts to wobble and 401k values start plummeting, it is hard to envision congress not acting quickly.

"I think some of our members may have thought the default issue was a hostage you might take a chance at shooting. Most of us didn't think that. What we did learn is this – it is a hostage that's worth ransoming. And it focuses the Congress on something that must be done.”
~ Senate Minority Leader Mitch McConnell in 2011

“Regardless of what may be said about the talks … the president and the Speaker will reach an agreement. It will ultimately pass on a bipartisan vote in both the House and the Senate. The country will not default.”
~ Senate Minority Leader Mitch McConnell this week

[Dan]

Yellen is ignorant.  Congress ALREADY passed a bill to raise the debt limit.  Somebody needs to tell her to open a newspaper.

[Jw2]

poor daniel, you are a bitter sexist loser. 

Where's you Ph.D? 

What school did you teach MBA students? 

Have you ever served in the Federal Reserve?

And she has a loving husband.


What would happen if the government defaulted?

There is general agreement that an actual breach of the debt ceiling would throw the economy in reverse. Importantly, default can mean different things. As laid out in contingency plans during a near default in 2011, the government would likely continue to make principal and interest payments on federal debt for as long as possible. The first things that would be cut or reduced are more likely areas such as salaries or Social Security payments. These actions would cost many, many jobs, but unless the crisis is prolonged, would almost surely be made retroactively and have only a moderate impact on economic growth.

The main narrative in the media portrays the country driving off a financial cliff when the government misses its first payment. But the magnitude and type of payments are very important. A short duration crisis would likely quickly be forgotten and fade into history.

It is worth noting there may be other outcomes. If talks fail, President Biden could attempt to invoke the 14th Amendment. This could spark a legal battle but may enable the Treasury to effectively raise more money. Alternatively, the Treasury could potentially mint a trillion-dollar coin, deposit it at the Federal Reserve and then draw on it to make payments. Neither of these would be desirable, or even necessarily possible or legal, but the point is there are additional options that can be considered if the worst starts to unfold.

How will capital markets react?

So far, capital markets are taking a mostly sanguine view of the situation. Stocks are trading near highs for the year, though in recent days have become increasingly correlated with reported status of the negotiations. While the primary concern for equity prices is a scenario where a default creates a deep recession and/or a liquidity freeze, simple anticipation could also create unpleasant volatility. In 2011, the S&P 500 dropped over 15% in just a few weeks as the deadline approached. A similar correction could easily start to materialize now. That said, given how close we already are to the deadline, a relief rally may be just as likely.

While yields for Treasuries maturing in June have risen meaningfully based on fears of a possible missed payment, medium to longer term yields have remained stable, indicating a level of confidence a resolution will be met. Ironically, even in the event of a temporary default, we expect government bonds will continue to be viewed as the safest and most liquid game in town. The dollar will remain the reserve currency. Once again looking at 2011 as precedent, despite the risk of default and a rating downgrade by Standard & Poor’s, Treasuries played their normal role of a safe-haven and rose in value during the market correction.

Attempting to sidestep short-term market corrections is generally counter-productive in our experience, and this is no different. It is difficult enough to time selling before a drop. It can be harder still to buy back in at a better buying point. Especially because equity prices tend to rise over time, few get both ends of this right. The initial Covid bear market and rapid recovery is a great recent example of how the market can take advantage of emotion and derail investor strategies. In 2011, stocks rebounded to new highs within six months. Most of those who sold in both instances probably ended up worse off for it. The current situation is, however, a good reminder of the benefits and risk reduction that can be achieved from diversification at the asset class and regional levels.

Having said all this, the debt situation is just one factor. Markets are also contending with higher interest rates, inflation, and an inverted yield curve and other signs we may see slower growth ahead. So far this year, stocks have been able to climb the wall of worry and bonds are again providing a meaningful yield. Higher volatility is likely to persist, but there is no way to be confident which direction it will favor.

But, you already knew that.

[Dan]

poor Dan, you are a bitter sexist loser.

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Liar.

Where's you Ph.D?;

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I can read.  I don’t need a PhD to know Congress passed a debt bill.

What school did you teach MBA students?

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Harvard. Why?

Have you ever served in the Federal Reserve?

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Twice.  Why?

And she has a husband.

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OK, you got me there.  I don’t have a husband. 

What would happen if the government defaulted?

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Red Herring.  The government won’t default unless it CHOOSES to not pay its bills in favor of discretionary spending.


If you had a PhD you’d know that.  Scratch that.  If you knew how to read, you’d know that, Fuhrer johniel.