What investors need to know as the U.S. debt-ceiling deadline approaches

Executive summary:

U.S. Treasury debt is considered the closest debt in existence to having no default risk. The ongoing game of financial chicken between Congress and the White House puts this assumption in doubt. Treasury Secretary Janet Yellen has estimated that the government may no longer be able to pay its bills starting June 1.
In 2011, a standoff over the debt ceiling in Congress resulted in significant market volatility, ultimately leading to an 11th-hour deal among lawmakers to avoid a default. In the aftermath of the drama, the U.S. government’s credit rating was downgraded by S&P.
If there is a technical default this time, it is very likely that markets will send the same message to politicians as they did in 2011—that a failure to resolve the debt standoff would likely lead to devastating results.

With the recent meeting between President Joe Biden, House Speaker Kevin McCarthy and Senate Majority Leader Chuck Schumer unsurprisingly failing to find agreement, political drama over the U.S. debt ceiling is once again playing out in Washington, D.C. Sadly, this isn’t the first time and probably won’t be the last.

Debt-ceiling drama: The 2023 version

By now the circumstances surrounding increases to America’s borrowing limit are all too familiar. Legislatively, there is a limit to how much U.S. debt can be issued, and in order for the U.S. government to spend more money, Congress needs to raise the borrowing limit, or debt ceiling.

The portion of government spending that matters the most is the servicing of U.S. debt—especially as it relates to market concerns. Just like any individual borrower, if the U.S. government misses a payment on its debt as a country, its credit rating will be impacted—and we all know the lower the credit rating, the higher interest that must be paid. Currently, financial markets consider U.S. Treasury debt as the closest debt in existence to having no default risk. The ongoing game of financial chicken between Congress and the White House puts this assumption in doubt—and if the U.S. misses a payment or is late with a payment, that assumption may be lost entirely. Suffice it to say the stakes are high.

The 2011 and 2013 debt standoffs: Crises narrowly averted

Constitutionally, Congress is responsible for approving government expenditures, including the money allocated to service and pay off debt. Therefore, once the debt ceiling is hit, lawmakers need to approve increasing the debt level to fund cash expenditures in excess of the current debt ceiling. Much of the time this is a fairly mechanical process, but at times it has become more politically fraught—including in both 2011 and 2013.

In 2011, the issue became the primary focus of markets and politicians, triggering significant market volatility in mid-summer. This sent a signal to politicians that the issue needed to be resolved immediately. Fortunately, with just 72 hours to go before a default, lawmakers came to an agreement on raising the debt ceiling. However, the deal wasn’t enough to prevent Standard & Poor’s from downgrading the U.S. government’s credit rating from AAA to AA+, with the credit agency citing concerns over the ineffectiveness of Congress to manage rising debt as one of the reasons for the downgrade.

In 2013, the issue reared its head again, leading to a partial government shutdown in October as lawmakers struggled to come to a consensus on raising the debt ceiling. The shutdown only ended when Congress ultimately agreed to suspend the debt ceiling until early 2014.

Markets likely to react strongly to a technical default

It is anyone’s guess on how this version of the dance will end. As I like to say in this business, forecasting the economy and markets is extremely difficult, and forecasting politics is nigh unto impossible. That said, if there is a technical default this time around, it is very likely that markets will send the same message to politicians as they did in 2011—that a failure to resolve the debt standoff would likely lead to devastating results. While this would almost certainly lead to a quick resolution, we would all rather that it doesn’t have to come to this.

Are there other ways for the U.S. government to pay its bills?

This begs the question: Is there another way to address the current need for more cash to pay obligations outside of standard, congressional-authorized spending and the Biden administration overseeing the spending of those funds? There are two unorthodox approaches currently being discussed. However, both of these approaches—as U.S. Treasury Secretary Janet Yellen has pointed out—are very unlikely, even if they are technically possible.

The first—the through-the-looking-glass approach, starts with the “minting” of a $1 trillion coin. The U.S. Mint (a bureau of the U.S. Treasury, which is an executive branch of the government) would be responsible for this. The next step is to “deposit” this coin (literally) in their bank—which is the Federal Reserve. In exchange, the Treasury would allocate $1 trillion dollars to fund the spending. As fanatical as it sounds, this may actually be legal, but the risks to the Biden administration and the Federal Reserve in going through with this would be enormous. To put it bluntly, the risks of doing this are so big as to make this nothing but a great theoretical idea, with almost no chance of actually be used.

The second approach is for the administration to invoke the 14^th Amendment to the U.S. Constitution. Specifically, this would rely on Section 4, which 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.

It is safe to say that the constitutionality of this move is questionable, and aside from leading to a review of it by the Supreme Court, the political risks of circumventing the separation of powers spirit of the U.S. Constitution would be huge for the Biden administration. Again, the predictably massive risks of this approach are enough to probably make it highly unlikely—and Yellen, again, has said as much. (As an aside, the insurrection language is in there because this was one of the Reconstruction amendments that followed the end of the Civil War. In short, the states that had comprised the Confederacy had balked at having to pay the Union’s costs in fighting the war.)

The bottom line

As the clock races toward June 1—the date Yellen has estimated that the Treasury Department may no longer be able to pay its bills—it is very unclear when a deal could be reached. It’s worth noting that any resolution to the current standoff will have to be worked out by politicians whose lines of demarcation are even more pronounced than they were back in 2011 or 2013.

In our next article, we’ll explore the potential impacts of even a short-term technical default. In the meantime, we’ll continue to keep you apprised of the latest developments and their impacts to markets.