Insights

The debt limit is the total amount of borrowing authorized by Congress to cover its bills - Social Security and Medicare benefits, salaries, tax refunds, interest, and other payments. Since the US government spends more than it takes in, the US Treasury must borrow by issuing new bonds – it has been unable to do so since it reached the limit in January. Now past the annual surge in tax receipts, the Treasury has been paying its bills by shifting cash between various internal accounts. Unless Congress lifts the ceiling, the government will run out of cash sometime in June.

The consequences would be significant. Just how bad we can’t say, because it has never happened before. Since 1960, Congress has acted on 78 occasions to suspend or raise the limit, thereby avoiding default. 

Each debt limit episode has its own political drama and can be particularly contentious when Congress and the White House are not controlled by a single party. This time around, House Republicans have a slim majority. They have declared that they will not vote to raise the ceiling without cuts to spending authorized by Congress in last fall’s budget. It is a game of chicken where all are hurt if no one blinks.

The US government has faced numerous debt limit standoffs in the past fifteen years. The August 2011 episode is the most notable because it led to heightened market volatility, increased borrowing costs, and, most famously, Standard & Poor’s unprecedented downgrade of the government’s credit rating. US equities fell 16% in eleven trading days from a week before the x-date (8/2/11) through the following week as negotiations dragged on. Foreign stocks fell in unison. Government and corporate bonds held up, advancing 1% over that period.

It was a needlessly horrible event. Moreover, the eventual compromise included spending caps that observers now believe stifled economic growth while the nation was still recovering from the GFC. Like now, Republicans controlled the House, while Democrats held the Senate and the White House. August 2011 is a distant memory, especially for the House of Representatives (according to congress.gov, the average tenure for Representatives at the beginning of this term was 8.9 years).

Virtually everyone assumes an agreement will be reached that prevents a default. The negotiations are likely to go down to – and perhaps even past – the wire, as they did in 2011 when Biden and McConnell ultimately cooperated behind the scenes to avert further damage. Ironically, a willingness to compromise may emerge only when people and markets begin to stress out.

We agree that the debt limit will be raised. The question is when – how much volatility will we encounter before a deal is reached? That is hard to assess - we will be looking for signs that both sides acknowledge the importance of financial stability and are each willing to blink. While a cautious stance is warranted, the recovery can be rewarding. The S&P 500 regained pre-crisis levels in six months and advanced 25% in the twelve months following the August 2011 low.