by Joseph V. Amato, President and Chief Investment Officer—Equities, Neuberger Berman
While markets have been appropriately very focused on inflation data and interest rate decisions, there are other issues that warrant attention from investors.
Last week, the Congressional Budget Office (CBO) projected that the U.S. government would run out of money sometime between July and September. Sounds ominous.
Specifically, it said that, unless Congress raises the federal debt limit, the “extraordinary measures” the Treasury can use to access additional funds could be exhausted as soon as this summer.
That would leave the government no option other than to default on its payments, including to bondholders—potentially undermining the global “risk-free” rate, the very foundation of the global financial system. While such an extreme event is highly unlikely, it is worth understanding the path to resolution.
Extraordinary Measures
Congress and the President need to approve any rise in the federal government’s debt limit, and they have done so more than 100 times since World War II.
The current limit was set at $31.38 trillion in December 2021. That level was hit a month ago, on January 19, and the extraordinary measures kicked in. The Treasury began to temporarily redeem existing investments from various public-sector workers’ benefit plans, and suspend any new debt issuance to top them up.
Secretary of the Treasury Janet Yellen wrote to the Speaker of the House of Representatives, Kevin McCarthy, to warn that these measures would be exhausted on June 5 and “urge Congress to act promptly to protect the full faith and credit of the United States.”
It's in the Treasury’s interest to make Congress feel urgency over the debt limit. Uncertainty over things like March and April’s tax receipts make it impossible to know exactly when the coffers would run dry. The CBO thinks the Treasury’s cash balance, and some other, smaller extraordinary measures, could keep it afloat a while longer than the June/July timeframe.
Nonetheless, the fact that its worst-case estimate differs from the Treasury’s by only a matter of weeks should get people’s attention.
Downgrade
Do investors need to worry? Well, yes and no.
Before the Global Financial Crisis (GFC), raising the debt limit was a formality. Since then, it has occasionally been a flashpoint, partly due to politics becoming more polarized and partly because of genuine concern about the sustainability of steeply climbing government debt levels.
The most serious blow-up so far was in 2011, when Republicans, who had gained control of the House of Representatives that January, demanded that President Obama cut the deficit in exchange for their votes to raise the ceiling.
Congress ultimately had to pass complex legislation—the Budget Control Act—to secure those votes. That legislation imposed spending cuts that, while demonstrating some fiscal discipline, probably also slowed the economic recovery from the GFC.
More immediately, it meant that the U.S. came within a couple of days of default in August 2011. Standard & Poor’s, which had given the U.S.’s credit rating a negative outlook in April 2011, became the first major ratings agency in history to downgrade it from AAA, on August 5.
The markets paid attention. The cracks in the eurozone were the dominant source of market volatility, but this debt-limit crisis was the main reason the S&P 500 Index fell by 17% in August 2011 alone. It took six months to regain the lost ground. The price of gold soared by 25% over the summer but, ironically, faced with major financial catastrophe, investors still preferred U.S. Treasuries over almost everything else: The 10-year yield fell from 3.72% in February to 1.72% by September.
Split
The experience of 2011 did not scare politicians off, however. More wrangling followed in 2013, and, since then, lawmakers have often voted to suspend the debt limit rather than raise it.
We strongly agree with U.S. Federal Reserve Chair Jerome Powell that “the only way forward” is for Congress to raise the ceiling. But there are reasons to prepare for another very close call this year.
Congress is split once again, as it was in 2011. But this time the Republican Party’s narrow majority in the House of Representatives creates a challenging additional dynamic. Speaker McCarthy’s tortuous election in January is a worrisome indicator of how difficult it could be to instill discipline and secure the critical votes. Brinkmanship is one thing; ideological conviction is another.
Moreover, U.S. federal debt held by the public was 64% of GDP back in 2011 and it is 96% of GDP now—with the CBO now projecting it to reach 118% in 2033. The cost has risen, too: The U.S. 10-year yield averaged 2% between 2011 and 2021, and is now 3.8%. According to Strategas Research Partners, net interest cost as a percentage of tax revenues is set to double, from around 8% to almost 16%, over the next decade. The CBO projects a growing U.S. budget deficit, up from $1.4 trillion in 2023 to $1.8 trillion in 2028 and $2.7 trillion by 2033.
It’s getting more difficult to dismiss the debt hawks as ideologues. At some point in the future, though not right now, markets will focus on this issue in pricing the “risk-free” rate.
Political Drama
In the meantime, it’s worth remembering that some political drama can have a destabilizing effect on financial markets, especially when that drama concerns something so central to the way those markets function.
For all our confidence in the “full faith and credit” of the U.S., and for all the importance the market currently assigns to inflation, growth, jobs and the path of rate hikes, we think the looming U.S. debt limit could be a source of volatility over the next three to six months. We would, however, see such volatility in excess of economic fundamentals as an attractive investment opportunity.
