Zephyr Financial Solutions

Debt Ceiling Standoff: Unprecedented Uncertainty

Unless you have been living on a remote island with no access to the outside world, which sounds pretty fantastic right now, you have probably heard or read about the ongoing debt ceiling standoff that has taken over Washington.

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Unless you have been living on a remote island with no access to the outside world, which sounds pretty fantastic right now, you have probably heard or read about the ongoing debt ceiling standoff that has taken over Washington.

This saga sounds familiar, as it should, we have seen these “debt ceiling standoffs” before and will unfortunately experience it again at some point in the future. While we have experienced “standoffs” before, we have never experienced an actual U.S. Federal Government default.

The saying often goes – history doesn’t repeat itself but often times rhymes. With that being said it’s worth looking back to the last debt ceiling brinkmanship, the impact it had on financial markets and what to expect this go around.

The U.S. Federal government officially reached its $31.38 debt ceiling back on January 19, 2023, and has not been able to borrow more money. The clock is ticking as U.S. Treasury Secretary Janet Yellen recently stated that if Congress cannot agree to raise or suspend the debt limit, the U.S. Government may run out of money as soon as June 1. If the U.S. Government fails to make interest payments on Treasury securities, it will mark the first time in history that it “defaults” on its legal debt obligations.

While there has never been a default there have been close encounters and debt ceiling standoffs in the past. The closest the U.S Federal Government came to defaulting on its obligations was during the 2011 debt ceiling crisis. It took a last-minute agreement within the U.S. Government to raise the debt ceiling and avoid a dreaded default. However, there was a consequence to the standoff as the credit rating agency Standard & Poor’s downgraded the U.S. Government’s long-term credit rating from AAA (highest credit rating) to AA+ on August 5, 2011. As you can see in Figure 1, market volatility continued despite a resolution on August 2, 2011 (Figure 1).

Because an actual default on U.S. debt obligations is unprecedented, the actual impact on financial markets is uncertain. Despite the uncertainty, there are a few implications that are safe to assume.

Starting with the stock market. The stock market is likely to drop, and an increase in volatility due to the uncertainty of a default. An actual default is unprecedented and the closest measuring stick to the impact a default would have on equities is 2011. If you recall, back in 2011 the S&P 500 came within a whisker of falling into a bear market (20% fall from its peak), when the index fell a -16.3% in October from its April peak. Interestingly, most of the losses happened after Congress reached a debt ceiling agreement on Sunday, July 31, 2011. The S&P 500 fell a -5% from its April peak through July 31, a far cry from the -16.3% it fell in total. When you consider the majority of the equity losses took place after the debt ceiling agreement and the volatility continued, a bear market and an increase in volatility is a reasonable expectation if a default occurs (Figure 2 and Figure 3).

Short-term interest rates are likely to rise, which we have already experienced as yields on 3-, 6-, and 12-month Treasury bills have spiked since the beginning of May. Investors have and will continue to demand a premium to hold the securities with maturities that are within the period of a possible default (Figure 4).

There is uncertainty around the repayment of maturing Treasuries as there has been little talk or communication regarding potential payment prioritization, or the order in which what obligations will be repaid, delayed or not. The lack of serious discussion about prioritization makes it hard to come up with potential scenarios.  However, if an agreement is reached, which I believe will happen, and a default is avoided, holders of Treasuries will receive their interest and principal payments. Like I said above, yields on short-term Treasuries are likely to rise, making the yields attractive, but there are other risks. Reinvestment risk will increase when the higher yielding shorter maturity issues mature, and investors have to reinvest to proceeds in lower yielding longer term issues. And of course, you have default risk.

During the 2011 debt ceiling crisis,10-year Treasury yields fell as investors focused on the negative impact the higher short-term interest rates would have on the U.S. economy. Furthermore, investors were concerned that the spending cuts by the government would also hinder economic growth. With this in mind, longer term Treasuries may present more opportunities, despite lower yields than shorter-term Treasuries (Figure 5).

Additionally, a default would cause the value of the dollar to drop and a credit downgrade from the major credit agencies. In fact, Fitch Ratings has already placed the U.S. on a credit rating watch as the so-called x-date is approaching.

Here are some considerations when creating an investment portfolio for your clients based on what we learned from close encounter back in 2011 and the current market conditions.

Because a default is unprecedented, it’s important not to make big changes to your portfolio without the long term in mind, especially if the crisis is short lived and markets recover quickly. If your client has a long-time frame and is able to stomach the volatility, there will be opportunites to buy equities at lower valuations. Continue to focus on the long-term, your client’s investment objectives and their financial plans. This may also be a good time to revisit your client’s investment portfolios and financial plans to make sure your clients have enough short-term liquidity during this time of heightened uncertainty.

While I think a default is unlikely, it is prudent financial advisors talk to their clients about the implications of a possible default and have a plan in place in case the Government is unable to reach an agreement in the coming days and a default occurs.

Tags: Investment Research, Strategies for Wealth Management