We would all like to believe that the United States defaulting on its debt due to an arbitrary threshold (the “debt ceiling”) is unthinkable and unconscionable.
Unfortunately, a mistake and/or miscalculation by the opposing parties has become a risk that cannot be ignored, and the potential second and third order effects are unknowable. Even the first-order effects (i.e. the impact on the stock market, Treasury yields and the economy) are somewhat difficult to frame out other than in broad strokes based on historical precedent.
Equity markets decline precipitously. Who knows how deep the drawdown would be, but we wouldn’t be surprised to see something comparable to the drops we experienced during the early days of COVID. You may recall that on one day — March 16, 2020 — the S&P 500 fell 12.9%. During the 11th hour debt-ceiling negotiations back in 2011, the S&P 500 sank 17% and equity volatility tripled.
U.S. Treasury yields spike. It is difficult to imagine that a U.S. debt default would not trigger a Treasury bond sell-off. We are already seeing yields on Treasury bills maturing in June trading at a premium. Longer term, one would expect that U.S. bonds would no longer benefit from the pricing premium they have historically received due to their essentially risk-free status.
A U.S. recession, something that has been widely anticipated, becomes a near certainty. The magnitude of the negative impact on the U.S. and likely the global economy is unknowable. It would depend on the speed and substance of the policymaker response as well as how much consumer, investor and corporate executive confidence is shaken. The White House has published a document indicating a protracted default could lead to a 6% drop in U.S. GDP and a 5% spike in the unemployment rate (bringing it over 8%).
Keep in mind that the U.S. technically hit the debt ceiling back in January. Since then, our federal government has been funded through so-called extraordinary measures. The exact time when funding will dry up is referred to as the “X-Date” because no one knows for sure when that will happen, but it is generally expected to be sometime in the next three months, starting with early June out to August.
Let’s look at the likely non-default scenarios, excluding extraordinary measures (evoking presidential authority under 14th amendment, trillion dollar coin, Treasury issuing premium bonds), which are highly controversial and without precedent:
Agreement is reached to raise the debt ceiling before the X-Date. Crisis is averted and we move on. But this is a low probability scenario given political divisiveness. Also, short of passing legislation repealing the debt ceiling, another debt ceiling game of chicken would be in our future.
A deal is made to raise the ceiling before the X-Date by cutting government spending and clawing back unspent Covid relief dollars. This could add a fiscal drag on the economy on top of tightening monetary and credit conditions. At the risk of prognosticating, it is hard to imagine that a U.S. recession isn’t a certainty given this scenario.
Policymakers kick the can down the road with a short-term budget patch. How far the can will roll is a good question, with speculation indicating just a few weeks to allow more time to work out a deal. Or perhaps through the end of fiscal year 2023 (September 30th) or even into 2024 to raise the stakes for the U.S. elections. Markets don’t like extended uncertainty thus volatility would be expected to remain high.
After X-Date is breached, the U.S. Treasury pays interest and principal due on Treasury debt but prioritizes which other government obligations to fund or which to pay partially. This step may not even be operationally feasible given the volume of expenditures (and the complexity of restructuring systems for prioritized payment), and this would also likely face legal challenges as the U.S. Treasury would probably have to decide who gets paid and/or how much. Also, while not technically a default, this approach would essentially be perceived as such.
Attempts at Prioritization
During the 2011 debt-ceiling debate, policymakers did discuss paying out Social Security but delaying and/or reducing payments to active-duty military and veterans, defense contractors, Medicaid grants to state and local governments, and many other outlays.
Earlier this year, the House Ways and Means Committee approved the Default Prevention Act, which attempts to map out the prioritization of government payments once the debt and principal on U.S. debt has been paid. This has not been passed into law but it appears to be an attempt by the Republican party to outline their vision for prioritization. Under that proposal, payment of obligations would be prioritized as follows:
- Tier I: U.S. principal and interest payments, Social Security, Medicare
- Tier II: Departments of Defense and Veterans Affairs
- Tier III: Obligations of any program not in a designated tier
- Tier IV: Certain federal employee union activities; executive branch travel; compensation for the President, Vice President and some political appointees
- Tier V: Compensation to members of the U.S. Congress
A U.S. government default or even near-default would create a market shock. Does that possibility warrant making major portfolio changes now? We think not. The strategic asset allocation and specific components of our clients’ portfolios are geared to allow them to stay invested through market turmoil, knowing that their portfolios realistically reflect their need, desire and ability to take on a certain level of risk and target a necessary level of cash flow amid the potential for drawdowns.
Making major portfolio changes now in anticipation of how things will play out and additional reactive changes as events unfold just creates decision risk with a high probability for error. History has shown that even after the most unthinkable shocks, markets and the economy tend to recover over time.
That said, on a client-by-client basis, the debt ceiling negotiations may present an opportunity to make minor changes to portfolios that add value from a risk management or opportunistic perspective, depending on individual client circumstances and wealth plans.