The US debt ceiling remains a thorn in the side of both the economy and the markets. In fact, it’s reemerging as one of the greatest risks we see today. The debate in Congress is intensifying and the rapidly approaching “X-date”—essentially the point of no return—could arrive as early as the beginning of June.
While often a magnet for political showdowns, the debt ceiling has been raised, extended, or “redefined” 78 times since 1960, under presidents from both parties. Congress has suspended the debt limit seven times since 2013 alone (most recently in 2021). Even in 2011, the year the US came closest to a breach, Congress finally reached an agreement on the X-date itself. But that brinksmanship left a lasting mark, as S&P downgraded the US’s credit rating mere days later.
With the debt ceiling deadline looming, how might the standoff play out today? Our base case suggests that policymakers will find a solution this time, too…eventually. With that said, heightened polarization has made this current round the riskiest we’ve endured to date.
Both elevated risk and possible downside scenarios merit investors’ consideration. The range of potential outcomes in a technical default varies widely. That’s part of what makes it so nerve-wracking. On one hand, the impact could be mild, assuming a breach is short-lived. But an extended disruption could spark a deep recession without the potential remedy of fiscal support. For that reason, we’ll explore what happens if the debt ceiling isn’t raised, even though it remains an extremely low probability event.
What Is the Debt Ceiling?
Prior to WWI, the US government opted to issue debt for specific purposes, such as financing a given project. Yet making specific appropriations became more difficult during WWI and WWII. So, Congress gave itself more flexibility to spend and Treasury more authority to fund by simply capping the total amount of debt which could be taken on. Accordingly, the national debt is limited to a certain dollar value and cannot exceed that level.
A Fluid Situation
The situation in Congress is unfolding in real time, with each side clarifying their position ahead of the debt ceiling deadline. Democrats want to pass a “clean” debt ceiling increase while Republicans prefer pre-conditions aimed at reducing future government spending. Specifically, the GOP-controlled House has passed a bill which would suspend the debt ceiling in exchange for ~14% cuts to federal spending over the next decade.
As currently written, that bill has little chance of passage in the Democrat-controlled Senate and would be subject to a presidential veto. Yet with the debt ceiling deadline nearing, time is running out. Treasury is currently using “extraordinary measures” to buy time, but once those are exhausted, it will stop making payments.
An influx of corporate tax revenues expected in mid-June could extend the runway (assuming the government can hold out that long). Depending on the size of the corporate payments and further extraordinary measures, the runway could be extended into July and perhaps even August. Amid the uncertainty, the yield curve suggests that the market has currently priced in a chance of hitting the limit at some point over the summer (Display).
Whether before a breach or after, it could take a market panic to force holdouts to reach an agreement. If anything, the market’s currently sanguine reaction—which is putting little pressure on Congress—hasn’t fueled a sense of urgency. Such a feedback loop is troubling, as it means a market downturn may be required to force a deal.
Worst Case Scenario
What happens if the debt ceiling isn’t raised? Nothing good.
Based on their contingency plan from 2011, Treasury either couldn’t or wouldn’t prioritize payments, such as Social Security. While the federal government would theoretically remain open past the debt ceiling deadline, operations would be disrupted, with Treasury reducing outlays by roughly one-quarter to one-third.
From a market perspective, we’d expect a breach to unequivocally batter risk assets like stocks—in the near term. Paradoxically, it could prove beneficial for Treasuries. When S&P downgraded the US in 2011, a flight to safety forced global assets into US government bonds. Yet in retrospect, it’s hard to tell how much of that was due to the debt ceiling dance and how much stemmed from Europe’s own debt crisis.
Unlike typical sovereign defaults, which result in the restructuring of existing debts, Treasury bondholders would not risk losing their principal—their payments would just be delayed. As the debt ceiling deadline draws near, we’re already seeing Treasuries maturing around the X-date trade with higher yields than other bonds. And, like others, we’re avoiding those maturities in our own money market funds. Once a deal emerges, rates could temporarily climb as the market absorbs a wave of debt issuance.
Over the longer term, a technical default—even if brief—would likely undermine Treasury demand. As a result, US interest rates may drift higher as global investors reassess the risk of dysfunction in the US political and economic system. How much it dampens global appetite would likely depend on the length of the impasse.
The more ominous risk comes in weighing the economic effects. Even here, the feedback loop of markets and policy would come into play. If Congress quickly remedies the situation, our $26 trillion economy could escape virtually unscathed. But if the standoff drags on, we could see a situation that rivals the Global Financial Crisis—minus the possibility of government intervention. Moody’s estimates that a weeks-long breach could result in around 6 million jobs lost and the unemployment rate reaching as high as 7%.
Trillion Dollar Coin?
If the debt ceiling is breached, there are no good options, though two possible workarounds exist. Treasury could mint a “collectible” trillion-dollar platinum coin and deposit it at the Federal Reserve in exchange for cash. Or, Treasury could continue making payments as usual, pointing to the 14th Amendment for the authority to do so.
Either approach would heighten uncertainty, given potential legal challenges. Both the market and economy would respond decisively, though it’s impossible to gauge their reaction in advance. With all that said, we continue to expect cooler heads to prevail.
Positioning Ahead of the Debt Ceiling Deadline
Given the overall macro backdrop, recent market levels, and balance of risks, our base case still calls for equity markets to remain range-bound this year. We foresee headwinds pressuring corporate earnings and higher interest rates making bonds and other assets relatively more attractive. What’s more, a debt ceiling debacle would pose a sharp threat to the economy and markets. Investors with required distributions or other portfolio withdrawals should consider that risk closely.
Other investors—whose asset allocation matches their risk tolerance and financial objectives—should aim to weather short-term economic and market tempests while participating in long-term economic expansion over time. Currently, a slowdown is inevitable, a recession much more likely, and a debt ceiling breach an identifiable but extremely low probability outcome. Yet, unfortunately, that probability is not zero. Portfolios should reflect that balance of risks.