The Debt Ceiling & Investment Markets

January 27, 2023

On Thursday, January 19th, the US officially hit the debt ceiling of $31.4 trillion dollars. Thankfully, the consequence of this won’t be immediately noticeable as the US government has a number of workarounds which will allow it to function normally for a number of months. In that time, it is hoped that Congress can come to a resolution on the issue and we can move on with our lives. But, as days and weeks go by without a hint of compromise on either side, it seems like we could be in for a drawn-out fight. With this in mind, we thought it would be useful to share more information about the topic with clients.

First, a little history. The US debt ceiling was created in 1917 and has been modified (usually increased) over 100 times since then. The last time was 2021. For much of its history it has been a routine Congressional item that gets passed without much notice. Markets typically don’t react to a looming debt ceiling increase because of this.

When Congress is divided however, raising the debt limit can become a messy affair. 2013, 2011, and 1995 were the years where Congress couldn’t (easily) reach an agreement. It may seem counterintuitive, but the market didn’t seem to care all that much about Congressional dysfunction in these years. With the exception of 2011, market performance was actually very good (more detailed info below).

  • 2013—the debt ceiling fight started early in the year and resolved in October. The S&P 500 was unfazed and gained ~32% that year. The US bond market returned -2% (keep in mind this was the year of the “Taper Tantrum” where the Fed began selling down its balance sheet—this was likely a bigger driver of bond returns in 2013).

  • 2011—the debt ceiling fight was messier this year. Squabbling began in early 2011 and culminated in the S&P rating agency cutting the US credit rating in August. Markets were having an ok year up to that point, but lost ~13% in the late summer. Resolution was the passage of the Budget Control Act of 2011. The S&P 500 finished the year +2% and the US bond market gained roughly 8%.

  • 1995—The 1995 debt ceiling crisis resulted in a government shutdown. The S&P 500 returned 37% that year. The US bond market returned 18%.

So, while we are concerned about politicians flirting with the full faith and credit of the United States for political reasons, in past years these fights didn’t negatively impact investors in a major way. There is an argument that Congress is more polarized now compared to prior years and that coming to an agreement in this political environment could be even more difficult. While we agree with that observation, our expertise lies in financial matters, not political ones, and most DC pundits think the US Treasury will prioritize paying its debt service obligations above all else to avoid a default on US debt—an unthinkable economic scenario as US debt is the backbone of the modern financial world. And in the absence of a normal Congressional resolution, there are a number of ways the crisis could possibly be resolved too (below are three that have been getting some discussion in the news lately).

  • Option #1 – Use a “discharge petition” to force a floor vote. A major issue is that a bill to increase the debt ceiling isn’t even being voted on. This political maneuver would force a bill to the House floor for a vote. When faced with a public vote it is assumed Congress will pass a debt ceiling bill. The downside is that this takes months and we probably don’t have time before a default occurs.

  • Option #2 — Minting a trillion-dollar coin — A (fringe) theory that the Treasury could technically mint a trillion dollar coin and deposit it at the Fed. The money would then be used to service debt, etc. Treasury Secretary Yellen, importantly, has dismissed this idea.

  • Option #3 — President Biden invokes the 14th amendment – The 14th amendment clause “The validity of the public debt of the United States, authorized by law…shall not be questioned” could be used as justification for President Biden to order the Treasury to pay all government obligations, ignoring the debt ceiling. This likely sets up a Supreme Court fight about the constitutionality of the debt ceiling. The downside here is the optics. Having the full faith and credit of the US government debated and decided by the US Supreme Court isn’t inspiring to investors.

We are obviously hopeful that it doesn’t come down to those last three options. The ideal outcome is that Congress eventually starts negotiating and comes to an agreement well before the final hour. That said, even if politicians continue this game of chicken beyond normal bounds, the US government should have a number of options at its disposal.