Last Friday afternoon, amidst the lengthening shadows of a winter sun, the Treasury Secretary delivered an ominous warning: By this Thursday, the U.S. federal debt will reach its legal limit, requiring her to take extraordinary measures just to keep paying the bills.
Secretary Yellen’s warning was, perhaps, a little premature and she suggested that, with some adjustments, our real rendezvous with disaster might be postponed until June. But even this date is considerably earlier than many assumed in the middle of last year, due, in large part to the budgetary effects of the Federal Reserve’s aggressive tightening.
From both an economic and a financial perspective, a failure to raise the debt ceiling would be an unmitigated disaster. Today, as in the past, attempts to gain political advantage by holding the debt ceiling hostage amount to a juvenile game of chicken and both parties deserve the scorn of voters for not eliminating this fiscal doomsday machine years ago.
Moreover, debt ceiling theater has always acted as an easy distraction for those who minds ought to be focused on managing the federal budget in a responsible way. Both parties have contributed to a ballooning of the national debt over the past two decades, eroding future living standards and increasing the risk of an eventual fiscal crisis.
While a failure to increase the debt ceiling is the most immediate fiscal threat to the economy and markets in 2023, damage could also be done either by continuing to neglect deficits altogether or by inflicting very sharp fiscal tightening on an economy that is now thoroughly hooked on the drugs of monetary and fiscal stimulus. Investors can hope that Washington adopts a more sensible middle path. However, they would be well advised to consider how their portfolios might hold up under a messier outcome.
The Early Arrival Of ‘Date X’
The aggregate debt limit, or total amount of money that the federal government is allowed to borrow, was first established in 1917 and has been raised or suspended 102 times since World War II (Source: “The Debt Limit” Congressional Research Service, Updated November 22, 2022). Most recently, it was raised to $31.385 trillion in December 2021.
At that time, the actual federal debt subject to limit was $29.180 trillion and the Treasury had roughly $42 billion in its checking account at the Fed. This gave the federal government over $2.2 trillion in wiggle room, part of which was expected to fund a very big fiscal package. With the eventual package involving much more modest borrowing and an economic rebound boosting revenues, it appeared that the need for a debt ceiling increase could be postponed until much later this year. Indeed, analysis by the Bipartisan Policy Center last June, suggested that we would not reach “date X” (or the date at which the federal government cannot meet its obligations), until the third quarter of this year (“Debt Limit ‘X Date’ Further Out Than Expected, But Still Looms Ahead”, Bipartisan Policy Center, June 14, 2022).
However, since then, aggressive Fed tightening has worsened the situation. In fiscal 2022, the net interest on the public debt amounted to $475 billion. However, partly mitigating this were Fed profits of $107 billion paid back to Treasury. These profits are derived from the difference between the interest earned on the Fed’s massive portfolio of Treasuries and mortgage-backed securities and the interest that it pays on reserves which, until last March, was based on a very modest interest rate of 0.15%.
Since then, the Fed has raised short-term rates seven times, boosting the interest paid on reserves to 4.4%, essentially wiping out all Fed profits and remittances to the Treasury. In addition, we estimate that higher interest rates on Treasuries will raise net interest on the public debt to roughly $685 billion this fiscal year. Combined, these two items will add over $300 billion to the fiscal 2023 deficit, resulting in a shortfall for the entire year of roughly $1.3 trillion, far above the $984 billion deficit for 2023 projected by the Congressional Budget Office last May.
It should be emphasized that these numbers are very rough. Much depends on April tax revenues, which are always difficult to forecast and which have been even more challenging to estimate in recent years because of the impact of the pandemic and measures to combat its effects.
However, the bottom line is that, as of last Thursday, the federal debt was only $70 billion below its statutory limit while the Treasury department had $310 billion on deposit with the Fed. These balances will likely be drawn down to dangerously low levels before a rush of tax receipts in April, and then exhausted by renewed deficits in May and June, even assuming the deployment of now standard accounting tricks by the Treasury Department. (These include suspending normal Treasury contributions to federal retirement and disability funds as outlined by Secretary Yellen last Friday. See Letter to the Honorable Kevin McCarthy, January 13, 2023.)
The Consequences Of Default
All of this raises significant risks for investors.
The greatest risk is that political stalemate results in the government defaulting on the debt.
The White House Press Secretary, Karine Jean-Pierre said on Friday that the Administration expects Congress to pass a debt ceiling increase without conditions. Meanwhile, the new Speaker of the House, Kevin McCarthy, has said that any debt limit increase should be accompanied by spending cuts, echoing the demands of some of the holdout Republican members who finally elected him speaker earlier this month.
Any increase in the debt limit will require Republican votes in the House of Representatives and is difficult, although not impossible, to achieve without the Speaker’s support. If this process gets drawn out, and the Treasury runs out of money faster than it thinks, the U.S. could quickly find itself in a similar situation to the summer of 2011 when a debt-ceiling crisis triggered a market selloff and a downgrade of U.S. debt.
In that debacle, Treasury yields actually fell as global investors were also focused on the European debt crisis and Treasuries were seen as a safe-haven asset. This could happen again – at least initially.
However, an actual default on U.S. Treasuries could lead to a violent reversal of this trend as investors lost faith in future payments on U.S. debt. This could have dramatically negative impacts on a wide range of financial assets including U.S. bonds, equities and the dollar. Relative winners, in such an eventuality, could include real assets, high-quality international equities and the government bonds of countries perceived to be more fiscally responsible.
Financial chaos would, presumably, eventually lead to some compromise in Washington. However, this might not occur soon enough to prevent a recession and could leave some lasting scars, including a permanent increase in the cost of funding U.S. federal debt.
The Need For Steady Deficit Reduction
While investors should try to be prepared for the consequences of a debt ceiling disaster, it is also important to consider the implications of a continuation of “business as usual”.
The most relevant definition of the federal debt for the economy and financial markets is “federal debt in the hands of the public,” which excludes money owed by one part of the federal government to another.
Twenty years ago, the federal debt in the hands of public was $3.7 trillion, or 33.2% of GDP.
Ten years ago, the debt was $11.6 trillion, or 71.3% of GDP.
At the end of last month, the debt was $24.5 trillion or, we estimate, 96.2% of GDP.
The main reason for this ballooning in federal debt has not been a surge in “steady-state” federal spending or a plunge in “steady-state” revenues. In fiscal 2023, we anticipate federal revenues to equal 18% of GDP and federal outlays (excluding interest) to equal 20.9% of GDP—not hugely different from their 17.5% and 18.8% of GDP respective averages seen over the prior five decades.
Rather the biggest problem is that neither the extraordinary spending to stimulate the economy in the wake of the Great Financial Crisis and the pandemic nor the 2017 tax cuts were ever offset by either higher taxes or spending cuts. Moreover, the lack of public pushback or even debate about most of these actions suggests that deficits and debt will lurch upwards again in the years ahead.
This, in turn, could lead to higher borrowing from abroad and higher domestic inflation. It could also constrain future spending and result in higher future taxes, likely inflicting financial pain on older and richer Americans. It could even, eventually, lead to a different type of debt crisis where global investors doubt not just the willingness of the U.S. government to service its debt but also its ability to do so in a non-inflationary way.
A Debt-Ceiling Disaster Emergency Kit
It should be stressed that it is still quite possible that, after extensive posturing, a compromise will be forged, allowing for some deficit reduction in return for an agreement to raise the debt ceiling. Such fiscal restraint, in an economy already weakened by high interest rates and a strong dollar, could lead the Fed to reverse course, cutting interest rates by the end of the year. Such a scenario could ultimately be positive for financial assets.
But it is also important to be prepared for a worse outcome.
In the days after 9/11, the federal government suggested that everyone should have an emergency kit, which, as I remember, included items such as batteries, duct tape and bottled water. Initially, I thought this was just a waste of money. However, once our fears of an actual attack subsided, we made good use of all of these items in our day-to-day lives.
Similarly, a debt-ceiling disaster emergency kit would start with broad diversification and could include real assets and high-quality international stocks and bonds, denominated in foreign currencies. We, of course, hope that disaster is avoided. However, given still relatively cheap overseas valuations and the current under-exposure of U.S. investors to overseas assets, these adjustments may well make sense even if Washington doesn’t trigger a debt-ceiling disaster.
David Kelly is chief global strategist at JPMorgan Funds.