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This Again (the Debt Ceiling)

This Again (the Debt Ceiling)

October 27, 2023

The U.S. debt limit, also known as the debt ceiling, is back in the news. The debt limit is the total amount of money that Congress has authorized the U.S. government to borrow. In order to increase the debt limit, the legislative cap has to be raised by a majority vote in both the House and Senate. Importantly, the debt ceiling increase would be to enable Congress to pay future legal obligations that have already been made, not to increase spending outside of the approved budget. Congress is currently negotiating the debt limit because Republicans have a majority in the House and Democrats have a majority in the Senate and control the presidency. If the debt limit is not eventually raised or suspended, the U.S. Treasury would likely face a funding crisis that could impact a range of federal spending commitments. Ultimately we believe this is unlikely and therefore is headline noise.

Strategists are spending a lot of time thinking through three scenarios: (1) a non-event where Congress passes a bill before any undue market stress (low likelihood with minimal impact); (2) temporary financial stress until the current political standoff is broken (high likelihood with medium impact); and (3) a non-resolution leading to a U.S. default and extreme financial stress (low likelihood with significant impact). Analysts then assign a probability to each scenario and discuss positioning. In our view, it is all content for content's sake. Investors feel like they always need to be analyzing something to justify their current positioning, but very few investors actually act on the analysis. In the end, the analysis and event are simply noise. We have no reason to expect anything different this time.

While unlikely, failure to raise or suspend the U.S. debt limit could strain financial markets. It is difficult to predict the exact outcome, but potential strains include falling asset prices, a global recession, a weaker USD, a U.S. credit rating downgrade, and a delay or impairment in government functions and services, such as social security checks, salary payments, and national park operations. In our view, the most worrisome risk is a downgrade of the U.S. government's credit rating, which could happen even if a hard default does not occur (i.e., S&P's downgrade in 2011). It would call into question the 'full faith and credit' of the U.S. government and likely increase Treasury yields across the curve. An increase in Treasury yields, which are often used as the risk-free rate to price loans and other credit securities, would flow through to businesses and individuals in the form of higher borrowing costs.

While we are monitoring debt limit negotiations, we are more focused on what matters long-term (corporate earnings, economic activity) and most (investors’ goals and objectives, and risk management). Debt negotiations are a big event with significant potential implications for financial markets, and we acknowledge negotiations will grab headlines, impact the narrative, and drive near-term returns and volatility. However, we remain disciplined and not reactionary, for it is impractical to position entire portfolios for a tail risk, such as a hard U.S. default, given tail risks are by definition a low probability event.