As a reminder, the debt ceiling is the total amount the US government can borrow, and currently stands at around $28.5 trillion1. A big figure, but bear in mind the US economy turns over roughly $21 trillion each year2. The debt ceiling has been raised or suspended 78 times3, partly in acknowledgment of the fact that a bigger economy (in real as well as nominal terms) can support a bigger debt pile.
We’ve been here before: in 2011 and 2013, raising the debt ceiling became a focus of political point-scoring in a similar way to today. In 2011, negotiations over increasing the debt ceiling went down to the wire, prompting S&P to downgrade America’s credit rating to AA+.
Preventing the Treasury from issuing new debt would almost certainly result in a deep recession, and this is something neither side of Congress wants to be blamed for. Beyond the consequences for the economy, there would be the less tangible, but in some ways more significant loss of American prestige – cherished notions like ‘American pays its debts’ – at a time when China is vying for top spot.
These are habitual constraints, and pretty much insurmountable in most peoples’ minds – i.e. the consequences of not raising the debt ceiling are so bad that it will never come to pass, at least for the foreseeable future. Given today’s circumstances, with the economy still recovering from Covid, the chances seem even more remote.
It seems highly unlikely to us that Biden would try to unilaterally raise the debt ceiling under the 14th amendment, or that the Fed would print money in order to directly service the Treasury’s debt. Instead, we expect the debt ceiling to be raised or suspended as has been done previously, and we have not adjusted positioning in our portfolios to any meaningful extent to take account of the alternative scenario. The following is therefore more of a hypothetical thought-exercise on the implications of not raising the debt ceiling.
What would happen if the debt ceiling wasn’t raised? According to the Congressional Budget Office, the Treasury is expected to run a deficit of approximately 5% over the next 12 months, financed by debt. This includes only previously agreed spending, as opposed to the Democrats’ ambitious infrastructure and social packages. If the debt ceiling isn’t raised or otherwise circumvented, the Treasury won’t be able to borrow this 5% of Gross Domestic Product, and it follows that every expenditure, including debt servicing and repayment, will receive a 5% haircut, plus or minus a bit for truly variable spending (which will be cut to zero). While we would expect the Treasury to try and find avenues to prioritise certain spending over others (for example, debt servicing over salaries and expenses for government employees), there would be legal challenges to any such action. Similarly, prioritisation would present serious practical challenges given the sheer volume of payments executed by Treasury staff using the same computer systems.
Were a haircut to be applied to Treasuries, this would leave a hole in bank balance sheets around the world, prompting banks to sell assets and reduce new lending. Hence there would be significant global contagion. The Fed would cut interest rates, lower forward guidance and step in to buy Treasuries, as it has done in the past for troubled assets. Transcripts of Fed meetings from 2011 and 2013, show that they stood ready to continue accepting defaulted Treasuries4.
Would the price of Treasuries go up or down? This new default risk would put upward pressure on yields, but rates of return in the economy would all reset lower as the US economy and most likely the world, entered a recession. Hence ultimately we may well end up with lower yields and higher bond prices.
Should we therefore be buying Treasuries? First point to remind you, is that bonds are extremely expensive by any historical standard, and this will always be the primary consideration when it comes to our positioning: predicting the future is hard.
We expect the debt ceiling to be raised, but, more importantly, we think this whole debate is something of a sideshow compared to what’s going on with inflation. Whether a US default would push Treasury prices up or down is hard to gauge, but it’s clear where we see, and conversely don’t see, value today, with only circa 18% of our multi asset portfolios invested in government bonds (on a duration adjusted basis, and with most of this in inflation-linked government bonds), compared to 40% in a typical balanced portfolio.
1Financial Times, “Why are US lawmakers arguing over the debt ceiling again?”, 13/09/2021. 2World Bank US GDP in current USD, 31/12/2020. 3U.S. Department of the Treasury. 4Financial Times, “The debt ceiling: can the US avert a disastrous default?”, 05/10/2021