What the Debt Ceiling Means for Markets
The debt ceiling and specter of the United States defaulting is generating loud headlines. The volume will likely increase in the coming weeks, as the government runs out of money absent a resolution.
The U.S. has never defaulted on its debt. A default means that the government would fail to make scheduled payments on the tens of trillions of U.S. government bonds, notes, and T-bills that are the backbone of the global financial system. It would be an enormous self-inflicted wound.
Of course, just because everyone can foresee an avoidable catastrophe doesn’t mean logic will prevail. With politicians at the helm, it’s foolish to speak too forcefully about what will happen.
Still, a default that triggers a major, sustained crisis is extremely unlikely. Here are a few reasons:
The government has a variety of arcane tools to avoid default.
If the government runs out of money, it will prioritize which bills to pay. It may pay bonds and defer other obligations (e.g., Social Security or payroll for federal employees). Those missed payments would create tremendous pressure to find a resolution.
If there is a default, the stock and/or bond market would likely fall, pressuring Congress in two ways – (1) furious constituents and (2) panic from watching their own portfolios.
A default might compel the U.S. Federal Reserve (“the Fed”) to intervene and stabilize markets.
Thus far, the markets seem unbothered. Through Wednesday, the S&P is up 8.3% and the Barclays U.S. Aggregate Bond Index is up 2.8% year-to-date.
Part of the unconcern is due to the sad fact that we’ve gone through this drill before.
In 2011, the government reached the debt limit and avoided a default at the very last minute. Standard & Poor’s downgraded the U.S.’s credit rating for the first time ever.
Per conventional thinking, the near default and downgrade would cause a jump in interest rates. U.S. Treasuries would be less attractive, and investors would demand to be paid more.
Instead, the 10-year U.S. Treasury rate rapidly fell 1% following the drama (see below), and the bond market rallied. It is another example that anticipating future events does not necessarily lead to a reliable market forecast.
The stock market was relatively calm until the downgrade announcement. In the four days post-downgrade, the S&P 500 index yo-yoed wildly: -6%, +5%, -4%, +5%. Yet, over the following year, the index appreciated about 20%.
As we approach early June without a resolution, there will be A LOT of panicky headlines. Beware scary prognostications about what it means for your portfolio and what you should do about it.
Here is what is reasonable to expect if there is a default:
Owners of U.S. Treasury bonds may experience a delay of scheduled payments.
The stock and bond market may experience heightened volatility. No one knows how much and how long this may last.
Long-term investors know that they must endure countless bouts of short-term volatility. Self-inflicted political dysfunction is a particularly frustrating cause. Hopefully, the current crisis does not reach the 2011 stage or worse before resolution.
We do not anticipate adjusting portfolios due to default risk. We will let you know if our thinking changes. Please reach out if you have any questions or concerns.