The debt ceiling is a self-imposed limit on the amount of money the US government is permitted to borrow. The government does this by selling Treasury bond and then uses the money to finance interest on previously issued debt, pay salaries and benefits. When the debt ceiling is reached the US Treasury cannot issue any more debt. It can only pay expenses from collected tax revenues.
This past January our government reached the debt ceiling limit of $31.4 trillion1. After reaching the limit, the US Treasury began to rely on “extraordinary measures” to continue to meet the government’s obligations. Without an increase, suspension or elimination of the debt ceiling the government cannot issue more Treasury bonds. Thus the government must make a decision to not pay interest owed and effectively default. In such a scenario government leaders must choose to prioritize paying debt obligations or delay paying federal employee and retiree wages and benefits.
What would happen if the US defaulted on its debt?
The good news is it has never happened. The bad news is it has never happened, so there is no historical precedent to look back on. Given it is truly an unknown event, the effects are truly uncertain. The possible impacts of a protracted default that isn’t resolved quickly is purely speculative, but impacts could be felt in the following ways:
- A decline in Gross Domestic Product (GDP)
- Government employees, retirees and recipients experience reduced or deferred payments.
- Business spending would decline
- A sharp rise in rates would have a negative affect on stock prices creates higher risk premiums
- The dollar would likely drop as investors are less inclined to hold dollar assets which would lead to higher risk premiums
- Liquidity in markets could be severely impaired
- Monetary policy would shift to accommodative to re-stimulate growth
So what should you do with your portfolio?
How one responds is going to be a matter of risk tolerance. If you are risk averse, then a few options to consider are:
- Avoid purchasing Treasuries around the X-date or Treasury securities at all temporarily.
- One-month Treasuries have become extremely expensive
- Do not place cash in money market funds. Money funds that invest in short government securities are in the same situation. Avoid a scenario wherein government/treasury money markets that aren’t supposed to have redemption gates face a liquidity squeeze
- Consider using FDIC limited balances in CD’s if you don’t trust the government. Ironically, one could extrapolate the potential of reversing fears of bank runs as money flows into deposits from government securities
- Don’t recommend selling all equities. Do expect volatility. Hold cash and look for opportunities to deploy it opportunistically even into international equities
Opportunistic investors might look to take advantage of market price swings:
- Looking at prior events such as 2013 when the country was on the verge of default, Treasury yields remained relatively stable and the S&P 500 Index actually rose. This might be an opportunity to add to equities and buy from panic sellers willing to accept any price
- Continue to focus on the longer term beyond this event
- Just keep buying Treasuries as normal. Yields on three-month Treasuries which mature beyond the projected X-Date continue to rise while shorter dated paper continues to get expensive
1 Source: Congressional Budget Office https://www.cbo.gov/publication/58945
2 Source: United States Treasury https://home.treasury.gov/policy-issues/financial-markets-financial-institutions-and-fiscal-service/debt-limit