Debt Ceiling: What Investors Should Know
Investors have been uneasily watching the standoff in Washington over raising the federal "debt ceiling" before the U.S. government runs out of money to pay its obligations. An agreement has been reached, and now the pressure is on Congress to pass the deal before the June 5th default date. While we at Schwab believe that a government default is unlikely, fears around the issue are likely to affect market performance in coming days. Here are some of the questions we're hearing from investors about the current situation, the implications of a default, and what you can consider doing now.
What is in the debt ceiling agreement?
The small team representing the White House and House Republicans that had been negotiating a solution for more than two weeks announced on May 27th that they had reached a deal to suspend the debt ceiling until January 1, 2025. At that point, the Treasury will be able to employ its so-called "extraordinary measures" for several months, so it will be mid-2025 before Congress will have to confront the issue again—well after the 2024 presidential election and with a new Congress in place. The legislation also reduces discretionary federal spending for two years, but the cuts will not impact defense spending (which will see an increase in the coming year) nor will it affect Social Security, Medicare or veterans' health care programs. The agreement would also repurpose nearly $30 billion in unspent COVID funds and as much as $20 billion in funding for the IRS that was approved last year. It also includes reforms to the permitting process for energy projects, new work requirements for some recipients of food stamps and an end to the freeze on student loan repayments that has been in place since the pandemic.
Will the agreement be approved by Congress in time to avoid default?
We believe Congress will pass the bill, but there may be some bumps along the way. The House is expected to vote on the measure late on May 31st. House leaders are scrambling to cobble together a coalition of Republicans and Democrats to vote for the bill, since some members of both parties have already indicated their intention to oppose it. Once it passes the House, the bill will proceed to the Senate. The timing of a final vote in the Senate is uncertain because of the ability of any single senator to use procedural maneuvers to delay consideration. But lawmakers are confident that they will be able to pass the bill and send it to the president for his signature in time, even if it takes into the weekend of June 3-4 for final passage.
What is the debt ceiling and why do markets care?
The debt ceiling is the total amount the U.S. government is authorized by Congress to borrow to meet its existing obligations, including interest payments on Treasury securities. It's currently $31.4 trillion. The government hit that limit in January 2023 and has been using accounting maneuvers that get around the debt ceiling (referred to as "extraordinary measures") to pay its bills since then. On May 26th, Treasury Secretary Janet Yellen told Congress that the Treasury would run out of money to pay its bills on June 5th unless Congress raised the debt ceiling.
If the U.S. government should fail to make interest payments on Treasury securities, it would have "defaulted" on its legal debt obligations for the first time in history, and the market reaction likely would be very negative. We also believe that if the Treasury made its debt payments on time but didn't make timely payments on its other financial obligations (e.g., salaries, Social Security payments) the market reaction also would be negative.
Hasn't this happened before?
There has never been a default. The closest parallel to the current standoff is the 2011 debt ceiling crisis, when the U.S. government came the closest it has ever come to a default before a last-minute agreement was approved by Congress to raise the debt ceiling. It was resolved on August 2, 2011. Although the U.S. did not default, credit rating agency Standard & Poor's took the unprecedented step of downgrading the U.S. government's long-term credit rating from AAA (the highest credit rating) to AA+ on August 5, 2011, and market volatility continued even after there was a resolution.
Why has there been so much uncertainty about the exact date a default would occur?
The flow of receipts and outlays at the Treasury is inherently unpredictable, making it difficult to pinpoint an exact time for default. In three different May letters to Congress, Yellen had included a carefully worded caveat that the default could occur "as early as June 1." The May 26th letter is the first time that Yellen has not used "as early as." That's a message to Congress that June 5th is the hard deadline it had been seeking all along.
Is a short-term extension possible?
A short-term extension is unlikely, but it remains a last-minute option if it is needed to avoid default while negotiations over a longer-term deal are continuing.
Can't the president invoke the 14th Amendment?
Some have said that President Joe Biden could invoke Section 4 of the 14th Amendment and just direct the Treasury to keep paying its bills (the section reads "the validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellions, shall not be questioned"). However, Yellen has downplayed this idea as "legally questionable." Such a move would likely be challenged in court, resulting in a period of uncertainty while the case moves through the courts, which itself would be disruptive to the markets and economy.
What impact would a default have on markets and the economy?
Because this has never happened before, there is more uncertainty about this event than other forecasts, but we believe stock markets would drop and short-term interest rates would spike (in fact, this already has happened for Treasury bills maturing near the expected default date), there would be a drop in the value of the U.S. dollar, and major credit rating agencies would downgrade the U.S. government's rating. It could also mean a long-term rise in the cost of borrowing for the U.S. government, given the erosion of its pristine credit history.
On the economic front, a spike in interest rates and likely hit to consumer and corporate confidence—and a decline in spending—would probably cause job losses and move the economy from the rolling recession that the U.S. is currently experiencing to a full-blown recession.
If a default happened, how long would it last?
Again, there is no historical precedent in the United States. An extended period of nonpayment of sovereign bond interest and principal has happened in emerging-market countries, but not in major developed countries. In the U.S., the problem wouldn't be inability but unwillingness to pay.
When negotiators reach a deal, it would still take some time for Congress to approve it. The deal would have to be turned into a bill that gets debated and voted on in the House. Then the Senate would have to approve the exact same bill. That process would normally take one to two weeks. Congress can speed that up by waiving certain rules, limiting amendments and taking other steps, but it would still take at least a few days. Only when the agreement has passed both chambers and been signed into law would the debt ceiling officially be raised and the Treasury be able to resume making payments.
Couldn't the Treasury pay some bills and not others until Congress reaches an agreement?
Paying some obligations but not others would still be considered a default, as not all obligations are being paid. This is known as "payment prioritization." However, there is no playbook for which bills would get paid and which would not, and it's not clear who would have the authority to make those choices. It is widely assumed that payments to support the Treasury markets (e.g., interest and principal to bondholders) would be the top priority, likely followed by Social Security payments and military/veterans payments. But officials would quickly face difficult choices about who gets paid and who does not. Yellen also has said that Treasury's computer systems are programmed to pay all bills as they come due and do not have the capability of paying some bills and not others. Finally, anyone or any entity not getting paid in a timely fashion would likely sue.
What impact would a default have on money market funds?
If Treasury securities default, it could trigger SEC Rule 2a-7, which generally requires a money market fund to sell a defaulted security. However, the rule allows a money market fund to continue to hold the defaulted security if the fund's board of trustees determines that its sale would not be in the best interests of the fund and its shareholders.
What impact would a default have on Treasury securities?
The debt ceiling drama already has boosted volatility in short-term rates. Short-term Treasury bill yields have risen as investors require a premium to hold them during the time frame when default risk is considered to be elevated. We don't expect a default, but the debate could go down to the wire and keep volatility high at the short end of the yield curve.
On the longer end of the curve, the 10-year Treasury yield fell during the 2011 debt ceiling standoff (remember that yields move inversely to prices). Markets were focused on slowing economic growth driven by the rise in short-term interest rates, plus the risk that government spending cuts would hurt economic growth even more. Also, long-term Treasury bonds were still seen as a safe haven in time of turmoil.
What does this mean for investors who hold U.S. Treasury securities?
Repayment of maturing Treasury securities could be delayed until the debt ceiling is raised. Unlike the 2011 debt ceiling debate, there has been little serious discussion of potential payment prioritization, where certain obligations could be repaid on time but others aren't. Without guidance from the Treasury, we don't know what will happen, and a delayed repayment of maturing Treasury securities is one potential scenario. Assuming an agreement eventually is reached, investors would receive their interest and principal payments—likely with extra accrued interest.
Treasury investors may want to:
- Consider the consequences of a delayed repayment for Treasury securities that mature on June 5th or in the days afterward. If you are relying on an on-time payment of a maturing Treasury security, consider whether there are other solutions available for covering that spending.
- Evaluate the bond portion of their portfolio and consider having adequate exposure to intermediate- and longer-term bonds, rather than too heavy a weighting toward short-term bonds. Although short-term bonds currently offer relatively high yields, bond holders risk having to reinvest maturing securities soon and possibly at lower rates. It might be better to lock in intermediate yields now (they're currently running between 3.5% to 4% for Treasury securities maturing in 3 years to 10 years).
- Focus on high-quality, higher-rated investments, rather than corporate junk bonds or emerging-market bonds. If the economy should weaken or the U.S. government default, those high-risk debt instruments would come under the most pressure.
What impact would a default have on U.S. stocks?
We don't know, but it probably wouldn't be good. For those looking for a parallel in the 2011 debt ceiling crisis, recall that the debt ceiling agreement was reached on Sunday, July 31, 2011. By that time, the S&P 500 had declined only 5% from the year's peak, which had occurred in April. However, by Friday, August 5, 2011, when Standard & Poor's downgraded the U.S. credit rating, the S&P 500 had declined by nearly 18% from its April peak. In the following months it bounced around and eventually reached a total peak-to-trough decline of 19.3% in October 2011, just short of the traditional bear market threshold of 20%. Of course, there was an actual agreement reached in 2011. The absence of an agreement this time would likely usher in more volatility and downside risk.
Would a default (or the risk of one) accelerate "de-dollarization"?
It's likely that the value of the U.S. dollar would fall in in the event of default, as it would erode confidence in the United States as a safe and reliable place to invest. It's not clear how far or how fast it would decline. It could undermine confidence in the dollar as a major reserve currency, although the path to replacing it with another reserve currency is not clear.
What does Schwab suggest that investors do?
It's important to consider that it's hard to say exactly when the crisis will be resolved. It wouldn't make sense to make big changes in your portfolio if the crisis were resolved quickly and the market snapped back. That said, it's always a good idea to be ready for the unexpected. We suggest investors consider the following:
- Have a liquid emergency fund. We suggest three to six months of cash (outside of investments) for essential spending. If you're especially worried about recession, or if you think you have a higher risk of job layoff or more volatile income, an even higher reserve might be useful.
- Don't forget money needed soon. This is particularly important for people who are in or near retirement, or who have short-term goals like buying a house or paying for college. Typically, bear markets have tended to last less than four years (peak to trough to peak) so a four-year cushion should be enough to weather a typical bear market. This money can be allocated to cash investments and high-quality, short-term bonds.
- Have and stick to a long-term investment plan. A default could usher in a period of increased market volatility. You should be prepared to control what you can, including your emotions. Be prepared in advance to react to volatility, with cash on hand to help you avoid having to sell more-volatile securities at potentially depressed prices.
- Be flexible with debt. If you have been aggressively paying down debt—for example, prepaying your mortgage by making extra payments—you may want to consider preserving capital during times of uncertainty while continuing to make all required payments. Extra debt payments can't be taken back if you should need cash, so maintaining flexibility during uncertain times can make sense. Again, this applies mostly to people whose income may be affected by interrupted government payments.
- Consider creating lines of credit. These shouldn't generally be used for discretionary spending, but can be a useful source of capital in addition to cash for short-term liquidity or emergency, to avoid the need to sell investments emotionally or during periods of stress or down markets.
Are there more advanced strategies that investors can use?
There are several strategies involving the use of options. On schwab.com/learn there are a number of articles describing strategies that may be relevant to consider in this situation.