Debt ceiling drama will likely rattle markets
This report is current as of March 17, 2023
The 118th Congress convened in January with razor-thin majorities in both houses. Democrats hold a 51-49 majority in the Senate, while Republicans have a 222-213 advantage in the House of Representatives. The sharp divide between the two chambers means few major legislative accomplishments are expected in the current biennium.
But there is one critical issue that will require a bipartisan solution soon: the debt ceiling. As the debate unfolds, markets will be watching closely to see when and whether Congress will raise the debt limit.
The debt ceiling is the cap Congress puts on the total amount of debt the United States can accumulate. Congress raised the cap to $31.4 trillion in December 2021. On January 19, 2023, the U.S. hit the cap, meaning the Treasury can no longer borrow to pay the nation's debts. The Treasury Department began taking "extraordinary measures," a series of administrative steps to ensure the country does not default, but those measures are expected to run out in late June or early July. Congress must either increase or suspend the debt ceiling by then or risk a potentially catastrophic default.
Both parties have already staked out their positions. President Biden and Congressional Democrats have said they will only support a "clean" debt ceiling increase, with no strings attached. Republicans are demanding that a debt ceiling increase be paired with significant spending cuts to get the federal deficit under control. The president met with new House Speaker Kevin McCarthy (R-CA) at the White House in early February. While the meeting produced no substantive developments, the fact that the two sides are already sitting down to discuss the issue a few months before the deadline is at least a modestly positive sign.
The market's concerns stem largely from painful recollections of the 2011 debt ceiling battle. Washington had the same political configuration then as now—a Democrat in the White House, Democrats controlling the Senate, and Republicans controlling the House. The two parties couldn't reach an agreement in the weeks leading up to the default date, rattling the markets. The S&P 500 fell 16% in five weeks, volatility spiked, and Standard & Poor's downgraded the U.S. credit rating for the first time in history. At the last minute, Congress reached an agreement to raise the limit, but, while the markets stabilized, it was not a process anyone wants repeated.
This year, there is again no clear path to a solution. But leaders of both parties have been adamant that they won't let the country default. Markets will be watching carefully as negotiations pick up speed this spring.
Bank collapses spark questions on Capitol Hill
Another issue that has captured the attention of lawmakers and regulators is the stunning collapse of Silicon Valley Bank, the second-largest bank failure in history. Two other mid-sized banks – Signature and Silvergate – also failed in March, while Credit Suisse received support from Switzerland’s central bank and First Republic of San Francisco received an infusion of cash from 11 large US banks. Though anxiety about the possibility of contagion in the banking sector is high, the reaction on Capitol Hill thus far has been relatively restrained. While there have been calls for legislation to tighten regulations on mid-size banks, it is unlikely that common ground can be found in the split Congress. Indeed, key Congressional leaders from both parties have said that regulators have the necessary tools at their disposal. Expect a series of hearings on Capitol Hill in April asking tough questions of the Federal Reserve and other banking regulators about whether it should have better anticipated the turmoil, but, for now, a legislative response looks unlikely.
Cryptocurrency gains bipartisan support
Elsewhere on Capitol Hill, one financial issue is attracting bipartisan support: creating a better regulatory structure for cryptocurrency. In the wake of the collapse of cryptocurrency exchange FTX last fall and other bankruptcies in the crypto space, interest is high on both sides of the aisle for legislation to increase investor protections and clarify which regulator has primary authority over cryptocurrency. The House Financial Services Committee created a new subcommittee on digital assets, a clear sign that the issue has high priority. And the Senate Banking Committee held the first in a series of hearings on crypto issues in February. It's one of the few issues on Capitol Hill generating truly bipartisan interest, so it merits watching to see whether lawmakers can pass a bill this year.
SECURE 2.0 glitch causing confusion
One surprise that has popped up is the discovery of a drafting error in the new SECURE 2.0 Act, the package of retirement savings enhancements that was signed into law in late December. The glitch appears to prohibit catch-up contributions in 401(k) plans in 2024 and beyond. The error stemmed from a change in the new law that requires catch-up contributions to be made on a Roth basis. In making that change, drafters inadvertently dropped a paragraph from the existing law, effectively eliminating all catch-up contributions next year. Both Congress and the IRS are aware of the issue and are exploring fixes, such as passing a technical corrections bill on Capitol Hill or using IRS guidance to clarify the mistake. For now, though, this one is in the "stay tuned" category.
Dizzying regulatory agenda continues at the SEC
It's often said that a split Congress emboldens regulators, who see an opportunity to fill the void when gridlock prevails. The Securities and Exchange Commission seems to be taking that to heart, as it continues its astonishing pace of regulatory proposals, several with potentially dramatic implications for the markets, individual investors, and RIAs.
Late last year, the SEC proposed a sweeping overhaul of equity market structure that alters how retail trading works. The proposal calls for most retail orders to be sent to an auction system at the exchanges. It would also permit shares to be priced in fractions of a penny, strengthen standards and disclosure around "best execution," and limit payment for order flow. Comments on the proposed changes are due March 31, but the proposals are already generating considerable pushback and threats of legal challenges.
Another notable proposal would overhaul mutual funds by strengthening funds' liquidity risk-management programs, requiring funds to employ "swing pricing" on any day there are net redemptions, and imposing a "hard 4 p.m. close" for funds. The latter would require that orders be received by the funds by 4 p.m. each day, a move that would force intermediaries to stop taking fund orders well before market close in order to process and bundle orders by the deadline. Retirement plan participants would likely see a mid-morning cutoff for placing orders and lose the ability to make same-day exchanges from one fund to another within the plan.
The industry strongly objects to the proposal. In a February 14 comment letter, Schwab said that the proposal could destroy mutual funds by putting them at a significant disadvantage to other products, such as ETFs, that could continue accepting trades right up to the market close. "The one-size-fits-all approach is so prescriptive, so operationally challenging, and so unfriendly to investors that we question how long the mutual fund industry would be able to survive under these rules," wrote Schwab President Rick Wurster. The SEC is reviewing comments and expects to finalize a rule by the end of the year. The mutual fund industry hopes that near-universal opposition to the plan will convince the SEC to consider alternatives.
The SEC is also finalizing a series of rule proposals with direct impact on RIAs. These include new disclosure requirements for RIAs making ESG-related recommendations to investors; new cybersecurity requirements for RIA firms; and new due diligence and monitoring procedures for RIAs that use third parties for some services. In February, the SEC proposed new rules regarding the custody of assets, including, for the first time, cryptocurrency assets.
Finally, in February, the SEC released its 2023 list of examination priorities, including several areas of focus for RIAs. Topping the list are compliance with the new Marketing Rule, which went into effect in November, and Regulation Best Interest. The Division of Enforcement said it would be looking at compliance with the fiduciary standard and recommendations made by advisors to investors. It noted that there would be particular focus this year on recommendations involving complex products, such as derivatives and leveraged ETFs, high-cost products, microcap securities, and "unconventional strategies that purport to address rising interest rates." The agency also said it would be scrutinizing advisors to private funds, recommendations about cryptocurrency, and whether recommendations for retail investors about ESG strategies are made in the investor's best interest. And the agency is continuing its crackdown on the use of personal mobile devices for conducting business. RIA firms should ensure they have policies and procedures in place to verify that employees are not using personal phones for business purposes without proper archiving and monitoring.
It's a busy agenda, to say the least, as the SEC continues its aggressive efforts to strengthen its regulatory oversight of the markets and advisors.