The federal debt limit is once again approaching a critical June 1 deadline. Media across the spectrum, mainstream and financial, have picked up on this and it’s prompting investor concern. It's unclear exactly how events will play out in the coming weeks, but we do know the deadline passing without an agreement would be a self-inflicted catastrophe for both political parties and our country. For now, markets are digesting the news fairly well, but what is the perspective investors should maintain around the political and fiscal uncertainty?
Federal borrowing reached the debt limit this past January
First, it's important to understand what the debt limit is. In simple terms, the federal government borrows money to pay its bills by issuing Treasury securities. This is necessary because the federal government often operates with a deficit whereby spending (on defense, Social Security, emergency pandemic stimulus, and more) exceeds government revenues (which consist primarily of tax revenues). While tax revenues increase as the economy grows (even without raising tax rates), they have been outpaced by spending over time. This borrowing adds to the national debt which hit the $31.4 trillion debt ceiling in January. Shortly after hitting the debt ceiling, Secretary of the Treasury, Janet Yellen, sent a letter to Speaker McCarthy describing "extraordinary measures" being employed to avoid a default on its obligations. Since then, Secretary Yellen has been very vocal that the Treasury will be unable to extend its "extraordinary measure" beyond the June 1 deadline.
The debt ceiling is a mechanism that requires Congress to approve additional borrowing above these levels. Thus, what makes this discussion confusing is that the debt ceiling is not about government spending per se. That spending has already been authorized through the normal budget process that takes place each year.
That leaves us with only one question regarding the debt ceiling. Can and should the government pay its bills? This is akin to signing the papers for a new car then afterwards requesting an increase to your credit limit. For most of us, the decision to buy something can't be separated from whether we will pay for it, even if it's with debt. Unlike the citizens of our country, the Congressional process for approving a budget by September 30 each year is separate from whether the Treasury can actually pay the bills. It's stuff like this that makes people shake their heads at the government.
Near-term Treasury rates have jumped but longer-term rates are steady
Second, the large and ever-growing national debt is a controversial topic that impacts the economy and markets in complex ways. Right now, Democrats, who control the White House and Senate, and Republicans, who control the House of Representatives, are in a standoff. On April 26, the House passed a debt limit bill by a narrow vote margin of 217 to 215. This would increase the debt limit through March 31, 2024 or until the national debt increases by another $1.5 trillion. However, it also includes provisions such as discretionary spending limits, the repeal of renewable energy tax credits, increased work requirements for benefits programs, and others. This makes it politically fraught and thus unlikely to pass the Senate and be signed into law.
There is usually plenty of political grandstanding around this issue with each side trying to gain the upper hand. Similar debt ceiling standoffs have occurred over the past decade with the limit suspended and raised in 2013, 2014, 2015, 2017, 2018, 2019 and 2021. According to the Congressional Research Service, the debt ceiling has been raised 102 times since World War II.
Fortunately, despite the headlines and investor concerns, these episodes had little long-term impact on markets. The U.S. has never defaulted on its debt, and nearly all economists and policymakers agree that doing so would lead to turmoil in the financial markets and increase borrowing costs for businesses and everyday citizens. The word "never" doesn’t mean that it can't and won't occur though. Over many years, politicians dug the country into this hole by not addressing spending and the national debt. At some point, the country will be forced to reckon with the years of fiscal irresponsibility; however, it is unlikely today. Politicians are notoriously short-sighted, doing what brings the least pain now, and that is to find a way to raise the debt ceiling for the 103rd time and wait until the 104th to do this all again.
The one exception to markets staying relatively calm occurred in 2011 when a similar standoff led Standard & Poor's, a credit rating agency, to downgrade the U.S. debt. The stock market fell into correction territory with the S&P 500 declining 19%. Ironically, the prices on Treasury securities increased during the 2011 debt ceiling crisis because, even though these were the exact securities being downgraded, investors still believed they were the safest in the world at a time of heightened uncertainty. The debt ceiling was eventually raised and a new budget was approved, allowing markets to bounce back.
Income tax rates are still low by historical standards
Third, debt ceiling aside, the national debt at today's level means that it has more than doubled over the past decade and, with very few exceptions, has grown nearly every year over the past century. While everyone generally agrees that the government should not spend more than it generates in tax revenues, the unfortunate reality is that neither party has addressed the problem. The last balanced budgets occurred during the Clinton years and the Nixon administration before that.
One factor beyond the market and economic effects is that the odds of higher tax rates may increase as the national debt worsens. Today, the highest income tax rates are slightly above their lows after the Reagan tax cuts, but still far below historical peaks. High-earners in the mid-1940s paid rates as high as 94% on their marginal incomes. Even those in the lowest bracket would have paid 20% or more during the 1940s, 50s and 60s - double today's rates. U.S. corporate tax rates were also among the highest in the world until the 2017 tax cuts. So, while higher tax rates are not guaranteed, consider taking advantage of today's historically low rates in positioning assets and consider how allocating deliberately can reduce some of the risks tied directly to the United States.
The debt ceiling and federal debt are and will continue to be an issue that needs to be resolved. Unfortunately, it's highly political and the headlines are very catchy so the news will be sure to capitalize on that. As with all political issues, it's important to separate the facts of investing from the opinions of politics. Businesses, like individuals, want to succeed regardless of the party in charge and investors should remain diligent in their investments and slow to react to fleeting headlines with their hard-earned savings and investments.
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