U.S. debt-ceiling debate heats up again

What is the debt ceiling?

The federal debt ceiling is a limit set by Congress on the amount of money that the U.S. Treasury can borrow to fund the government's operations and make interest payments to the people and institutions who own U.S. government-issued bonds. Treasury Secretary Janet Yellen has said that once the ceiling is reached, the Treasury will have to rely on so-called extraordinary measures to keep operating until Congress reaches an agreement for a debt limit increase. If the debt ceiling is not raised, the Treasury would be unable to issue more Treasury securities and the nation could default on its debt, potentially by June.

Although a potential default sounds worrisome, history suggests it is unlikely. "Congress has always acted to forestall default, though often at the last minute after considerable high-stakes wrangling," says Alice Joe, vice president for Federal Government Relations. Joe says neither party in Congress wants a default, but the highly partisan environment could make it harder to reach an agreement to extend the debt limit than has been the case in the past.

Though a default is unlikely, the environment in Congress may cause some short-term market volatility and the flurry of fear-inducing news stories that often accompany choppy markets. Lars Schuster, institutional portfolio manager in Fidelity's Strategic Advisers group says, "It's unnerving to see these headlines. The good news is that historically, volatility in the markets tends to be fairly short-lived. This could result in a good buying or portfolio rebalancing opportunity for long-term focused investors."

Many experts aren't worried about the debt ceiling

The debt ceiling has, in the past, spurred contentious and prolonged debate about fiscal responsibility and the growing national debt.

In 2011, the disagreements went so far that the credit rating agency Standard & Poor's downgraded the U.S. credit rating to AA+, one step below the best rating of AAA. Standard & Poor's cited the growing deficit and the prolonged debate as reasons for the downgrade.

Historically, raising the debt ceiling has not been a battle legislators want to fight. Administration officials usually work behind the scenes to convince legislators of the importance of raising the limit relatively quickly and without fanfare. This approach helps limit financial market uncertainty, minimizing the potential for government borrowing costs to increase amid a debt-ceiling debate, while reducing investor concerns.

Source: Congressional Research Service, Congressional Budget Office, and the Treasury Department. Data as of July 2022.

What is the U.S. national debt?

One thing separating today's debt debate from those of the past is the larger-than-ever national debt. Publicly held U.S. debt topped 120% of gross domestic product in the third quarter of 2022, according to the U.S. Office of Management and Budget.

And the debt is projected to increase significantly in the future. The Congressional Budget Office (CBO) projects the federal budget deficit will total $13.1 trillion from 2023 through 2032.

What if the U.S. debt ceiling is not raised?

Unless a deal is reached to suspend or raise the debt limit, the United States will be in danger of defaulting on our national debt. There are some steps the Treasury is taking to forestall a default, including spending down saved cash and other emergency measures. But those extraordinary measures are expected to be exhausted by sometime in June.

If all of Treasury's cash balances are drawn and extraordinary measures have been exhausted, the Treasury would be at the limit of the debt ceiling. Such an outcome has not occurred in the modern era, and it remains uncertain as to exactly what developments would transpire next.

However, if Congress still does not raise the debt ceiling, the U.S. government would have to operate on a cash-flow basis, meaning that outflows (including interest payments on existing Treasury debt) would have to be funded by inflows (i.e., tax receipts and fees). Operating in this manner would require prioritization of payments, which could have several negative implications.

Source: Fidelity Investments, July 2021.

For one, this prioritization would place some counterparties in a subordinate position, which could unsettle the markets. For instance, during the debt debate in 2013 when the United States was only days away from default, prioritization of payments was discussed as a possible option. While principal and interest payments could potentially continue to flow to bondholders, other payments like Social Security benefits could be suspended.

Also, the rating agencies would most likely place the sovereign rating of the United States under review and would potentially lower the rating if a debt-ceiling increase was not enacted. That could significantly increase the cost of borrowing at the national level.

Furthermore, critical functions to operate the government, including spending for military, Social Security, and other programs, would likely be interrupted, pressuring economic activity. Finally, the timing of tax collections is always uncertain, creating the potential for an inadvertent missed interest payment.

What happens if the United States defaults on its debt?

An actual default is highly unlikely because of the reverberations that could be expected, including:

Source: Fidelity Investments, July 2021.

What can your clients do about the debt ceiling?

It's clearly in the best interest of the country to resolve any debt-ceiling issues.

Still, there will always be times of uncertainty. It's important to take a long-term view of your clients' investments and review them regularly to make sure they line up with their time frame for investing, risk tolerance, and financial situation. Ideally, their investment mix is one that offers the potential to meet their goals while also letting them rest easy at night.