US Debt Ceiling: Not this again!

5 min read 24 May 23

The US Treasury has reached its limit on the national debt, and has been using ‘extraordinary measures’ to pay the bills since January. Its ability to do that is expected to end in early June, forcing it to miss some payments if the debt ceiling is not raised by Congress. If that happens, the US Treasury could stop paying interest on outstanding US government bonds. It could also stop domestic payments, such as social security, medicare and salaries of government employees.

There's hope that an agreement will be reached. The gulf between the different factions is narrowing, but the drawn out confirmation battle of Speaker Kevin McCarthy last year doesn’t give much comfort.

So what’s an investment manager to do? And what are the lessons and longer term implications?

2011 is the closest comparison we have, when the government came within days of a default and the ratings agency S&P lowered the credit rating of the US. The next day the S&P 500 Index fell 6.7%. General sentiment about the economic outlook was much more positive in 2011. Given the current worries about an impending recession, it’s unlikely the same scenario would lead to as steep a fall in equity markets today.

Paradoxically, in 2011 the USD dollar appreciated versus global currencies and longer dated US government bonds rose in value. The rally seems counterintuitive; the news that the US government bonds were no longer AAA-rated prompted investors to take sanctuary in US government bonds and the US dollar. This is because in periods of market turmoil, investors put more in US dollars and US government bonds. So, steering clear of these assets in the short term could harm performance. Currencies such as the Japanese Yen and Swiss Franc also tend to rise in value when there is turmoil in markets. Our portfolios have exposure to these currencies through holdings in Japanese and Swiss equities. We don’t hedge the currency risk for our equity holdings, because the exposure to different currencies provides diversification benefits.

Treasuries underpin the financial system. There's no simple hedge or place to hide in the short term. We think the best approach is to have a portfolio that is diversified across regions. No one doubts the capability of the US to pay its debts, however the political refusal to do so would erode confidence. The polarisation of politics is becoming a greater risk for investing, driven by technological changes that have given us social media, viral memes and an ever-quicker news cycle.

These are the longer term implications we see:

  • The US credit rating could be downgraded further. Investors may demand more compensation (e.g. higher interest payments) for taking on the risk that the US government doesn’t pay them back. That would push up the cost of borrowing and servicing debt. The means the US would need more revenue from taxes or less spending, because interest payments take up a larger part of the annual budget.
  • Most countries’ central banks hold US government bonds and US dollars. They rely on these funds as collateral for international payments. If interest or capital repayments are not made as expected, this could cause shortfalls for countries.
  • Banks hold US treasuries on their balance sheets. If the value of US government bonds fell, then this could cause funding shortfalls for banks, putting more pressure on the sector. 
  • The process of “de-dollarisation” of the global economy could accelerate. At present, countries and companies rely on the US dollar for commerce. Most key commodities are traded in dollars. This benefits the US because it means all those countries, companies and individuals need to own dollars. That gives the US the funding it needs to borrow relatively cheaply. If countries start holding more in other currencies and debt from other countries, then could drive up borrowing costs for the US in the long run.

The potential benefits from the debt ceiling standoff are small. It’s possible that if an agreement is reached on longer term spending cuts then it could put the US government in a stronger financial position over the long term.  But in the long run, economic growth tends to be driven by investment --  both by governments, companies and individuals – which drives higher productivity. If spending is reduced, then you could see less growth which would weight on the quality of US debt.

When an agreement is reached, the US Treasury will need to issue a significant amount of debt to make up for the lack of issuance in recent months. That could divert cash from other parts of financial markets, such as equities and corporate bonds, resulting in falls in asset prices. This means that even with a resolution, there’s likely to be an impact on financial markets. 

Past performance is not a reliable indicator of future performance. The value of an investment can go down as well as up and your client may get back less than they’ve paid in.

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