U.S. Debt Crisis – Is it time to use the nuclear option?

By David Nelson, CFA

They say the market climbs a wall of worry. I’ve been hearing that my whole career and for the most part, it’s true. In fact, it’s so true that when there’s nothing to worry about, it’s probably a good time to sell.

Part of the job in running money is to look out the windshield, hoping to steer around potential landmines. With the US bumping up against a self-imposed debt ceiling, there’s one more brick in the wall and one more challenge investors will have to navigate. Oh, we’ll make it over the wall. But if history is any guide, it won’t be without some heartache and pain along the way.

Pumping up the volume

YellenThe broadcast media has been pumping up the volume on the debt ceiling. We actually hit the debt limit a couple of weeks ago. Secretary of Treasury Janet Yellen is in the process right now of making extraordinary cash management adjustments to help put off the inevitable.

One example is suspending daily reinvestments in large government retirement funds that hold Treasury debt. There are lots of steps you can take, but in the end, time will run out.

When? Best guess right now is sometime in June, with some pointing to Monday, June 5th. Here is what could happen if we take it right up to the edge of the cliff.

Déjà vu all over again

In 2011, when we went down this path, markets we’re fairly sanguine about the coming deadline. Discussions were ongoing and all of us knew that eventually there’d be a resolution.

In May that year, President Obama pressed for a clean bill to raise the debt limit. That wasn’t going to happen, not with the political climate the way it was back then.

The Bottom Drops Out

Markets had been relatively calm, but on July 25th, the bottom dropped out. Historians point to a single trade that may have been the trigger. An $850 million futures trade betting on a U.S. default.

Source Bloomberg

Over the next couple of weeks, the S&P dropped more than 17%. There were frantic discussions in Congress with both sides blaming the other for the impasse. Multiple votes on legislation all failed. The Treasury Department estimated that the drop-dead date was August 2nd. Unfortunately, running out of time is often what it takes to get anything done in Washington.

The House passed a bipartisan bill August 1st, and the Senate passed on August 2nd. President Obama signed that legislation the same day. The Budget Control Act of 2011 ended the crisis, increasing the debt limit immediately with several measures to reduce spending.

President Obama declared the bill as an important first step to ensuring that as a nation, we live within our means. Despite a resolve in the crisis, Standard Poor’s lowered the credit rating of the United States from AAA to AA+.

I Win You Lose!

If anything, as a nation, we are more polarized today than we were a decade ago. We live in a world of I win you lose politics where the only thing that matters is that your side wins and the other side loses.

The White House right now is dug in and Kevin McCarthy had to concede a lot to become speaker. Under the new House rules, just one congressman can start a motion to vacate the chair. There were many negotiations with lots of holdouts taking till the 15th ballot for McCarthy to become speaker. You can bet one of the concessions was not to permit the raise the debt ceiling without a reduction in spending.

Source Bloomberg

Since 1960, Congress has raised or temporarily extended the debt limit 78 times. Today, that limit is 31.45 trillion. I know a staggering number and believe me when I say this. I fully understand the urgency to have this conversation. But know this going in. There is a cost and risk when you take it to the edge of the cliff.

One look at a chart of US Debt shows this path is unsustainable. Look, I understand that on the heels of COVID and the financial crisis, the rate of change would spike higher. But today, with COVID mostly in the rearview mirror, the administration seems to have its foot on the accelerator, as bill after bill coming out of Congress is in the $trillions.
The so-called Inflation Reduction Act does little to reduce inflation. Student loan debt relief adds to the problem and is an insult to every student and parent who paid off their loans. It’s not lost on Americans that this massive increase is in part responsible for the inflation battle we are in today, making the Fed’s job that much harder.
GROSS federal debt as a percent of gross domestic product is better than 120%. Higher than it was during World War Two.

Source St. Louis Fed

The Nuclear Option

Let’s be clear. Using the approaching debt limit to negotiate a needed reduction in spending, is the nuclear option. It’s not unlike when President Kennedy brought the world to the brink of nuclear war in protest of Russian nukes in Cuba. It’s a brilliant strategy, with just one problem…

What if the other side doesn’t blink?