Overview
The U.S. government hit its $31.4 trillion debt limit on January 19, 2023. Since then, the Department of the Treasury has been using extraordinary measures to pay its obligations. In early May, Treasury Secretary Janet Yellen told U.S. lawmakers that her department’s ability to use special accounting maneuvers to stay within the federal debt limit could be exhausted as soon as early June. Congress is now faced with overcoming political gridlock to address the debt ceiling within the next few weeks by either increasing or suspending the debt limit.
Bottom Line: We will likely experience heightened volatility within equity and fixed-income markets in May and June as the deadline approaches. Yet, if history is any guide, U.S. policymakers will likely find a compromise, and the market disruptions should be short-lived. The debt ceiling is a tail risk beyond an investor’s control. We urge investors to look beyond near-term volatility and focus on things that are within their control: sustaining a long-term focus, maintaining equity market participation and portfolio diversification, and sticking to a financial plan.
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What is the debt limit?
To meet the U.S. government’s obligations, the U.S. Treasury issues debt to investors around the world in the form of Treasury bonds, notes, and bills. Because the U.S. government runs a budget deficit, the Treasury continues to issue debt to fund its obligations, which results in the sustained growth of our national debt. The debt limit, which currently stands at $31.4 trillion, serves as a high-water mark for government borrowing. Chart 1 depicts the growth of the U.S. government’s debt load and Congress’s continued response to raise the debt limit over the years to satisfy its obligations.
Now that the debt limit has been breached, what happens next?
The U.S. government hit its $31.4 trillion debt limit on January 19, 2023. Since then, the Department of the Treasury has been using extraordinary measures to pay its obligations. In early May, Treasury Secretary Janet Yellen told U.S. lawmakers that her department’s ability to use special accounting maneuvers to stay within the federal debt limit could be exhausted as early as June 1st (known as the “X date”), yet the actual date will depend on variable revenue and spending flows. The Treasury’s timeline was reinforced by the nonpartisan Congressional Budget Office.
Congress is now faced with overcoming political gridlock to address the debt ceiling within the next few weeks by either increasing or suspending the debt limit. We will likely see members from both the Republican and Democratic Parties demand concessions as they negotiate a deal. Failure to do so risks a default. While the economic effects of such an unprecedented event would be destructive, there is an enormous amount of uncertainty surrounding the damage to the U.S. economy and global markets should a default occur.
How have markets reacted to past debt limit standoffs?
The most recent debt limit standoffs occurred in 2011, 2013, and 2021. Based on past market reactions, short-term Treasuries have been particularly sensitive to a debt limit crisis. 2013 saw the sharpest increase in yields in the weeks prior to the X date as the debt ceiling standoff resulted in the Federal Government shutting down in October until Congress increased the debt limit. Likewise, in 2011 and 2021, increases in yields were evident leading up to the respective X dates yet on a smaller scale. Currently, investors are demanding higher yields on Treasury bills due to be repaid in the summer months, which may reflect anxiety about the timing of a debt limit resolution. This week the U.S. government sold $57 billion of three-month Treasury bills at 5.14%, the highest for the benchmark issue since 2001.
The VIX Index, a financial benchmark designed to provide the expected volatility of the S&P 500 Index, has tended to react earlier than bond markets to the approaching X dates but with less consistent reactions (Chart 2). In 2011, the VIX rose ahead of the X date and subsequently spiked to 48 following the S&P downgrade of U.S. credit from AAA to AA+. In 2013, the VIX reacted in a more muted fashion, rising to 20. In 2021, a short-term resolution to fund the government from October to December saw the VIX increase to 30 as the December X date approached. Following the Treasury Secretary’s letter to Congressional leadership on May 1, 2023, stating the early June X date, the VIX Index increased from 15 to 20.
Ultimately, in all three instances of debt limit standoffs in 2011, 2013, and 2021, volatility was short-lived, as policymakers eventually compromised in all instances.
What should I do within my portfolio in response to the debt limit standoff?
Investors will likely experience heightened volatility within equity and fixed-income markets in May and June as the X date approaches. As experienced in past episodes, higher yields will likely be demanded for Treasury securities that mature near the X date, and the VIX Index will likely increase as the X date nears. Yet, if history is any guide, U.S. policymakers should find a compromise, and the market disruptions should be short-lived. The debt ceiling is a tail risk beyond an investor’s control. We urge investors to look beyond near-term volatility and focus on things that are within their control: sustaining a long-term focus, maintaining equity market participation and portfolio diversification, and sticking to their financial plan.
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Investment advice offered through CX Institutional, a registered investment advisor.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. The economic forecasts set forth in the presentation may not develop as predicted.
All data is sourced from Bloomberg, through the release of monthly figures from the U.S. Bureau of Labor Statistics or from the Federal Reserve and any of its affiliated regional location.