Today I want to look at the history of the debt ceiling, the likelihood of a default, the potential measures to be taken if that ceiling is reached without a deal, and the potential impact on US Treasury securities (aka US government bonds) and other investment assets.
“Human spirit is the ability to face the uncertainty of the future with curiosity and optimism. It is the belief that problems can be solved, differences resolved. It is a type of confidence. And it is fragile. It can be blackened by fear and superstition.”― Bernard Beckett, Genesis
How did we get here?
It makes sense to start this examination with a brief history of the US debt ceiling. The debt ceiling was imposed by legislation titled the Second Liberty Bond Act in 1917 setting the aggregate limit on the amount of bonds issued at $15B.1 The debt ceiling essentially prevents the US Treasury from issuing more bonds (i.e., debt) beyond an arbitrary amount set by Congress. Since 1940, this issue has come up every few years with the longest gap being an eight-year period between 1946 and 1954, but often coming up multiple times in a single year.2 I say this limit is arbitrary for a few reasons. On the one hand, it has been raised time and time again since the passage of the 1917 act. There are varying accounts of how many times the debt ceiling has been raised since then, but at least since 1960, Congress has increased the debt ceiling 78 times under many administrations with 49 of the increases occurring under a Republican administration and 29 under a Democratic administration.3 On the other hand, while there are laws which prohibit the US Treasury from borrowing beyond a certain limit, there are other conflicting laws which require the Treasury to service payments such as Social Security. No matter what the Treasury does in this circumstance, it is in violation of one law or another.4 The debt ceiling issue was further complicated by the passage of the Budget and Impoundment Control Act of 1974 which added complexity to the process. Prior to 1976 the US government never faced a government shutdown due to funding issues. Since 1976 there have been 22 shutdowns (partial or total) of the federal government due to lack of a federal budget.5 As of December 16, 2021, the debt ceiling was set at $31.4T. The point here is that the debt ceiling issue has been used as a tool by politicians of all stripes at the expense of Americans and the global economy.
How likely is a default?
The question arises today of just how likely it is that the US will default on its debts in 2023. In short, the consensus is that this is not very likely. In a poll conducted by JPMorgan Chase & Co. only 2% of respondents reported an expectation of a technical default. In fact, 79% of respondents expect a “last-minute short-term raise” of the debt ceiling. Further, both President Joe Biden and House Speaker Kevin McCarthy have said in recent days that “default is off the table”. While politicians will continue to jostle and posture as we approach the deadline, the expectation is that they will reach a deal of one sort or another. One way to think of this is that politicians may be receiving some benefit for pushing for their preferred talking points as we approach the deadline, but every politician will be harried by their angry constituents if they unnecessarily allow the US government to default on its debt obligations and tip the global economy into chaos.
What can the Treasury do if the deadline arrives without a deal?
While it may be unlikely that we in fact reach the deadline without some kind of deal, it is reasonable to consider the measures available to the US Treasury should the deadline pass without a deal. One big question on the minds of retirees is whether Social Security payments could be caught in the crossfire and a check missed. Social Security beneficiaries can rest easy. Since the inception of Social Security in 1935, the government has never missed a Social Security payment and there is no expectation that 2023 will be the year that streak ends.6 Social Security payments come from a trust that is separate from the Treasury General Account. One likely outcome of an impasse is that the federal government would furlough government workers as it did in 2013. This furlough lasted 16 days beginning on October 1 and ending on October 17, 2013.
This issue always raises a lively debate about creative solutions to a debt ceiling impasse. There are three ideas that have come up in recent years: invoking the 14th amendment, minting a platinum coin, and issuing low face value bonds with high interest rates. Invoking the 14th amendment is a complicated topic more suited for a blog on an attorney’s website, but essentially the idea is that the executive branch could argue that any law which might force the US government to default is unconstitutional. Despite acknowledgment from the Biden administration that this option exists, it seems that this is unlikely to be used given that other measures exist.4 The idea of minting a platinum coin with a high value (proponents often suggest $1T) and depositing it with the Treasury to raise revenue has been dismissed outright by Treasury Secretary Janet Yellen.7 The final suggestion may be the most likely. The idea is that the Treasury could sell bonds with little to no face value but high interest payments. This technically does not raise the amount of debt of the US government, only the debt servicing cost which is not capped by the debt ceiling. The government could therefore bring in revenue for operations without the need to issue large amounts of new debt. All these creative options are unlikely to be implemented, but it may help to understand these ideas as they are discussed in the news.
What is the potential impact of a default?
While it seems unlikely that we will face a technical default because of current negotiations, it is still reasonable to consider the potential impact on US Treasury securities and other investment assets should a default occur. The government has never defaulted on its debt obligations, so we do not have a historical reference point for such an event, but we can look at two recent examples of this debate in 2011 and 2013 to judge the impact of an impending default. It is likely that all this debt ceiling talk results in market volatility. While we can never predict the future, past experience
would suggest that stock prices may fall, and US Treasury prices may rise while investors shift assets away from risk and into perceived safe haven assets.
During the 2011 debt ceiling crisis Congress raised the debt ceiling two days ahead of the stated deadline of August 2 (in the context of 2023, Treasury Secretary Janet Yellen is setting this deadline as June 1). The stock market experienced significant volatility with the S&P 500 index falling 19.39% from its April 29 high to the October 3 low before rallying and ending the year down 1.12%. As a point of comparison that shows the defensive aspects of dividend paying stocks, VYM (the Vanguard High Dividend Yield ETF) which is a portfolio focused on dividend paying stocks was up 6.54% by the end of 2011 and the Howe & Rusling Equity Income Portfolio was up 11.43%. The S&P 500 ended the following year, 2012, up 13.41%. Standard & Poor’s downgraded the US credit rating for the first time in the country’s history from the long-term rating of AAA (the best rating) to AA+ (a half step down). It is important to note that even at a time when there was talk of the US government defaulting on its debt, the market retreated to the relative perceived safety of US Treasuries. From January 3, 2011, to December 30, 2011, the 2-year US Treasury rate fell from 0.61% to 0.25% (a 59% decrease) and the 10-year US Treasury rate fell from 3.36% to 1.89% (a nearly 44% decrease). The price and yield of US Treasuries have an inverse relationship, so a falling rate means an increasing price (i.e., investors buying US Treasury securities). In simple terms, stocks fell while US government bonds rose in value in the short term and the stock market recovered significantly a year later. Two charts below illustrate these points.
S&P 500 and VYM in 2011
2-Year and 10-Year US Treasury Rates in 2011
The debt ceiling crisis of 2013 had a more muted response in the stock and bond markets with the S&P 500 climbing 26.39% by year end with some significant turbulence along the way including a 5.76% drop over one month between May 21 and June 24, a 4.63% decline from August 2 to August 27, and a 4.06% decline from September 18 to October 8. The bull market in the S&P 500 continued throughout 2014 as well. Treasury rates climbed throughout the year with 2-year treasury rates increasing from 0.27% to 0.38% (a 40% increase) and the 10-year US Treasury rate climbing from 1.86% to 3.04% by year-end (a 63% increase). To simplify, stocks were on a strong rally throughout the year, but experienced some volatility during the period of debt ceiling negotiations; Treasury prices fell throughout the year although there were rallies in Treasury prices during those periods of stock market volatility.
S&P 500 and VYM in 2013
The bottom line of this discussion is that we are likely to see some form of a deal to push out or slightly raise the debt ceiling to kick this can down the proverbial road and are unlikely to see a technical default on US government debt in the next few weeks. It is not unreasonable to expect some stock market volatility and occasional rallies in US Treasury securities as we approach the deadline and even after a deal has been reached. Even with the volatility mentioned above and the downgrading of US debt in 2011, both 2011 and 2013 were part of the longest bull run in US stock market history. This debt ceiling crisis is just more noise in the short-term which should not cause undue stress for long-term investors.
I hope this article helps explain the current economic landscape and provide some comfort to our readers. As always, if you have questions, please reach out to us.
1 Sakolski, Aaron Morton. “Wall Street and the Security Markets”. 1925
2 “Table 7.1 – Federal Debt at the End of Year: 1940–2016″. Historical Tables. Office of Management and Budget. Retrieved May 16, 2011.
3 Congress has revised the debt ceiling 78 times since 1960. An expert explains why : NPR
4 Tommy Bennett on Twitter: “One of my con law students asked me about the debt ceiling and Section 4 of the Fourteenth Amendment. Since I took the time to write my response, I thought I’d share it here. Take it with the usual caveats, especially that I am not an expert in this area (that’d be @rohangrey) https://t.co/zon4NYBq27” / Twitter
5 Why is federal spending so hard to cut? — Recurring debt ceiling fights will only be solved by budget reform (brookings.edu)
6 What debt ceiling woes could mean for Social Security benefits (cnbc.com)
7 US Treasury’s Adeyemo dismisses platinum coin to skirt debt ceiling | Reuters