Do you worry about the US debt ceiling showdown?


If you've heard this one before, please stop us: US senators are at odds over raising the federal debt ceiling through legislation. The situation has been simmering for months, but it might boil over this summer when the US Treasury runs out of money to pay its debts. The decision to raise the nation's debt limit is usually simple, except when Congress is divided, as it is now. With Republicans controlling the House and Democrats controlling the Senate, the stage is set for one of the most heated debt ceiling debates in recent memory.

So far, Democrats have stated that they will not compromise on the matter, while many Republicans have stated that they will not vote to raise the debt ceiling without additional agreements to reduce federal spending. This could be the worst standoff we've ever seen, with the potential to be at least as catastrophic as 2011. That was the year Standard & Poor's downgraded the United States' cherished AAA credit rating to AA-plus (where it still is today) due to concerns about the government's budget deficit, a growing long-term debt burden, and political squabbles over raising the debt limit. The action initially alarmed US financial markets, but they rapidly rebounded.

In fact, not long after the credit rating action in 2011, U.S. equities launched into one of the longest bull markets in history, lasting from 2011 until the start of the COVID-19 epidemic. We believe the lesson from 2011 and the subsequent debt limit standoff in 2013 is that while these events can disturb markets for a while — often weeks or months — they aren't likely to have a long-term impact on investors, assuming a sensible conclusion. House Speaker Kevin McCarthy announced legislation on Wednesday that would expand the debt limit by $1.5 trillion. Several additional provisions in the plan aim to reduce federal expenditures. It was unclear whether the law would pass in its current form with enough support.

What if the United States defaults on its debt?

Of course, the concern is that the United States may end up in technical default on its numerous debt commitments, including payments to bondholders, in the midst of a particularly unpleasant debt ceiling dispute. It's difficult to anticipate what will happen next, but many believe it could roil financial markets and jeopardise the US dollar's role as the world's reserve currency. The chances of a technical default, which would occur if a bond payment was missed or even postponed, are very low but not zero.

It's critical to distinguish between the situation we're in now and something far worse, such as an Argentina-style default, in which investors lose their savings. Nobody believes that will happen. In our opinion, the likelihood of even a technical default, or delayed payment, in the United States is between 5% and 10%. It's not our preferred scenario, but it's also something we can't ignore. If the United States missed a payment on a short-term note due in June, for example, it would cause a market outcry, accompanied by high volatility for a day or two, and the debt ceiling standoff would likely resolve.

When a crisis occurs, it tends to set the political wheels in motion. If that happens, we believe Congress would act promptly to lift the debt ceiling, making investors whole.

The rule of unforeseen consequences

That is not to say that a technical failure would have no implications. Rating agencies may downgrade the United States' credit rating once more. Investors may raise the cost of future US debt issuances. Worse, some investors may no longer see US Treasury bonds as the safest investment in the world. We don't know what the consequences might be; for example, there are banks whose ratings are partially related to US sovereign ratings. Insurance firms, as well as government institutions are in the same boat. It's unclear what would happen if one or more of the rating agencies downgraded the United States again. We could see a chain reaction of downgrades, which would be disastrous for some financial firms. It's not something we can ignore, which is why we need a quick fix. We believe we will receive one; we just hope it arrives before any unexpected effects occur.

How much debt is excessive?

From the perspective of an equity's investor, the US debt ceiling dispute is entertaining political theatre, but it has little bearing on investing decisions. At the same time, we don't think it's always a bad thing to be reminded that the United States is more than $30 trillion in debt. Perhaps it's time to have a serious conversation about long-term budgetary responsibility.

If the above resonates with you, please contact us to for a free, no-obligation consultation: