The U.S. Has Reached Its Debt Limit. Now What?
On January 19 the U.S. reached its $31.4 trillion borrowing limit. Since then, the U.S. Treasury has resorted to “extraordinary measures”1 to extend the U.S. government’s ability to continue paying its expenses without breaching the debt limit. The Treasury will likely exhaust its options sometime between June and September, at which point it will reach the so-called “X date” when the U.S. government can no longer pay all of its obligations on time.
While the U.S. has experienced several government shutdowns in the past, the U.S. has never breached the X date before. As opposed to government shutdowns, which only impact discretionary spending, surpassing the debt limit would jeopardize all government spending—including Social Security, Medicare, Medicaid, and bond payments. Despite the serious consequences posed by breaching the debt limit, this possibility doesn’t typically receive much attention because most people view the likelihood of it happening as extremely low.
Currently, however, a split government and deep division between and within parties have increased the risk that Congress may not come to a consensus in time. Democrats are trying to raise the debt ceiling without any strings attached, while Republicans are calling for significant spending cuts. House Speaker McCarthy has met with President Biden, but initial discussions have resulted in little progress. Unfortunately, there’s not much incentive for either party to quickly reach a compromise.
Nevertheless, history would suggest little need for concern as Congress has acted 78 times since 1960 to permanently raise, temporarily extend, or revise the definition of the debt limit.2 In most of these instances, financial markets experienced minimal impact. As Congress has done in the past, we believe they are very likely to address the debt limit before the X date, because leaders of both parties understand the severe consequences of failing to do so. However, it would not be surprising to see lawmakers reach a compromise at the eleventh hour.
The closest the U.S. has come to breaching the X date was in 2011 when the debt ceiling wasn’t raised until August 2, the projected X date. The debt ceiling crisis caused the S&P 500 to fall 17% in just 11 trading days, from July 22 to August 8. Interestingly, the S&P 500 didn’t bottom out until several days after Congress raised the debt limit, due to additional fallout from the near default, including S&P’s credit rating downgrade of U.S. sovereign debt on August 5. Perhaps counter-intuitively, however, U.S. Treasury bonds rallied during that same period (as 10-year yields fell from 2.99% to 2.40%), by benefiting from an ironic “flight-to-safety” behavior by investors. With history as a guide, we would expect similar market volatility this summer as the X date approaches.
Even though we believe it is highly unlikely that the government would fail to reach a consensus by the X date, it’s worth considering what could happen if that does occur. Essentially, the Treasury would have to either cut spending by about 20% to balance the budget or pursue a potential loophole in order to continue meeting all of its financial obligations. If the Treasury chose the former, a recession would eventually follow as the necessary cuts would amount to around 5% of Gross Domestic Product (GDP). However, the Treasury might still seek to avoid a default—potentially the most catastrophic outcome—by prioritizing debt payments over other obligations, such as defense or entitlement spending.
On the other hand, the Treasury could pursue a potential loophole to continue paying all its obligations. What these potential loopholes lack in legal precedent, they make up for in creativity.
Options include:
- Minting (and subsequently depositing at the Federal Reserve) new platinum coins with an arbitrarily high face value, such as a trillion dollars, based on its authority to mint commemorative coins;
- Issuing bonds at a premium to raise additional money without increasing the face value of outstanding debt (upon which the debt limit is based); or
- Invoking Section 4 of the Fourteenth Amendment (which relates to Civil War-era debts) in order to ignore the debt limit.
The problem with all of these loopholes is that they would almost certainly be challenged in court and destroy confidence in the financial system.
Ultimately, if Congress doesn’t reach a resolution, then no matter what the Treasury does after the X date, there will likely be dire consequences for markets and eventually the economy and households as well. While we agree that the current U.S. fiscal path is unsustainable and hope that the current debt-limit debate will lead to spending cuts, we believe breaching the X date would be far worse than any kind of debt-limit resolution. We also believe this sentiment is shared by most politicians, and therefore are optimistic that they will come to a consensus in time—even if at the last minute.
Our investment team and advisors will continue to monitor the markets and economy as they always do. If you have additional questions, please reach out to your Blue Trust advisor or contact us at 800.987.2987 or email blog@bluetrust.com.