The debt ceiling debate comes to a head

Updated October 13 | Market news

Congress remains mired in another dispute centered on raising or suspending the federal government’s debt ceiling. Although this is a somewhat arcane procedure, as laws currently stand, it’s a required step to allow the U.S. Treasury to continue to issue debt to pay for federal government spending that has already been approved by Congress.

This is not a new issue, and in the past, Congress has always voted to suspend or raise the debt ceiling so the government can continue to meet its obligations without interruption. The need for such Congressional action has occurred nearly one hundred times since World War II. Most often, passage is a routine piece of business for legislators, but in some years, it becomes more of a political issue. The last time such a vote took place was in 2019, when Congress, in bipartisan fashion, lifted the limit on government debt until July 31, 2021.

What’s at stake

The federal debt is the total amount of money the government owes for spending on everything from Social Security and Medicare to defense programs and other types of domestic and overseas expenditures. The debt limit set by Congress represents the amount of funds that the U.S. Treasury is authorized to raise through debt security offerings to pay the operating costs of government.

In mid-October, Congress voted to extend the debt ceiling limit by nearly $500 billion. That is expected to fund the government until about December 3. Prior to that vote, the last authorization from Congress expired in July. In the interim, the U.S. Treasury Department used what are termed “extraordinary measures” to avoid running out of money. These steps included delaying deposits to government retirement accounts or to the Social Security Trust Fund.

Most expenditures that were delayed were for circumstances where the money was not specifically committed for payment at this time. “Necessary spending on natural disasters like Hurricane Ida forced the Treasury to spend some money that would have been relied on to extend the timeline for suspending the debt ceiling,” says Rob Haworth, senior investment strategy director at U.S. Bank. Time was running out on these measures allowing the government to continue to operate by the time Congress managed to pass the temporary measure to keep things running until early December.

In a recent commentary piece in The Wall Street Journal, Treasury Secretary Janet Yellen stated, “raising the debt ceiling doesn’t authorize additional spending of taxpayer dollars. Instead, when we raise the debt ceiling, we’re effectively agreeing to raise the country’s credit card balance.”1

If that doesn’t happen on a timely basis (by early December 2021), the federal government will not be able to issue debt and could run out of cash-on-hand. It raises the risk of the U.S. defaulting on its debt, as even interest payments on existing debt could not be made. Yellen, in her commentary, warned, “we could see indefinite delays in critical payments. Nearly 50 million seniors could stop receiving Social Security checks for a time. Troops could go unpaid. Millions of families who rely on the monthly child tax credit could see delays.”

If this occurred, it would likely be for a brief period assuming Congress comes to an agreement to suspend the debt ceiling limit again, but there could be other ramifications.

Some perspective on the debt ceiling debate

The key question is whether the situation will deteriorate significantly. “The debt ceiling issue itself is temporary, and ultimately, government spending catches up,” says Haworth. “The bigger question mark is what it might mean for the economy and financial markets.”

The most immediate effect could arise if the government potentially defaults on its existing debt obligations. “Such a move could cause creditors to demand higher interest rates in order to provide capital to the U.S.” If that occurred, it could cause subsequent rate increases for other types of debt, including mortgages, consumer borrowing and business capitalization.

A similar impasse occurred in 2011, when Republicans in Congress squared off against Democratic President Barack Obama over the issue of raising the debt ceiling. At that time, investment markets proved to be very volatile as a deadline approached to take action. Two days before the date when the Treasury Department estimated that it would run out of funds using extraordinary measures, Congress voted to raise the debt ceiling.

Another consequence, however, was a downgrade of U.S. Treasury securities below the highest, triple-A level for the first time in history, by a major credit rating agency. That did appear to cause higher interest rates on U.S. Treasuries as a result.

“While this potentially could raise concerns for the bond market, investors may at some point also become concerned with the fast-increasing level of debt that continues to emerge in the current federal spending environment,” says Haworth. He anticipates that at some point in the future, the amount of debt that’s been issued, much of it in the form of COVID relief, will impact the supply-demand balance for bonds, possibly affecting interest rates.

Economic and market considerations

If spending were curtailed in the event the debt ceiling is not lifted on a timely basis, that could cause a hit to the economy, though it’s expected to be short-lived. “Typically, one of the first spigots to be shut off is salaries to federal workers,” says Haworth. Ultimately, the pain may spread to those who receive direct payments from the government, such as Social Security recipients. “There are short-term impacts from that,” says Haworth, “but once funding is restored, everyone is usually made whole.” He points out that this can create financial difficulty for many and takes a meaningful human toll. Yet the overall impact to the economy is likely to be limited.

As for the investment markets, the debt ceiling confrontation does add a level of uncertainty to a stock market that is already valued at a modestly high level and is dealing with other issues. These range from the persistently high COVID-19 infection numbers to question marks about recent developments in China that may have economic consequences – including a seemingly stronger hand exercised over the free markets by China’s leadership and the recent financial difficulties facing a major Chinese real estate developer. “If the debt ceiling issue derailed confidence enough that companies began to scale back their own spending, that could have negative ramifications,” says Haworth. While there may be a period of short-term volatility stemming from the situation, Haworth notes that we’ve been in this position before and come out of it with no lasting damage.

What happens from here

The debt ceiling is one of two key budget issues that need to be addressed by Congress in short order. Just before the government’s fiscal year ended on September 30, Congress passed a temporary spending measure to fund the government through December 3. But no agreement has been reached on a budget for the full fiscal year.

While some Republican support helped to pass the budget measure in September and the debt ceiling extension in October, Republicans have signaled a reluctance to support votes in the future. The Democratic majority vote in the House would be sufficient to pass both on a party-line vote, but Republicans can block passage in the Senate, where 60 votes (each party currently has 50 votes) are required to move most legislation forward.

Republicans say if Democrats want to advance the spending and debt ceiling bills in the Senate, they should do so using a process called “reconciliation” that allows certain budget measures to pass with a simple majority in the Senate. Democrats have plans to use that provision in an effort to pass a multi-trillion dollar bill focused primarily on social domestic spending. For Democrats, this can be accomplished with all 50 of its members voting for passage, and then Vice President Kamala Harris providing the tie breaking vote as President of the Senate. However, Democrats are reluctant to connect the debt-ceiling bill to this significant piece of legislation.

Despite the current uncertainties, the situation over both the budget for the next fiscal year and extending the debt ceiling should be settled in the weeks to come. In the meantime, markets may demonstrate increasing concerns. The U.S. has never defaulted on its debt, and if the crisis grew to a point where that seemed to be a possibility, markets may react in a negative way. Yet Haworth sees the issue as temporary and one that’s likely to be resolved in a reasonable timeframe.

Keep in mind that while this issue may capture significant headlines, the debt ceiling and related legislative activity are just one factor to assess as you consider how your own portfolio is situated for the current environment and your long-term investment objectives. Talk to your financial professional if you have questions or want to determine any options that should be considered for your portfolio.

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