The Debt Ceiling: A High Stakes Game of Chicken

With the U.S. facing an unprecedented default on paying its debt last month, Congress kicked the can down the road to Dec. 3. What could happen to stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company. and bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. if Capitol Hill is unable to raise the debt ceiling next month? Here’s what Director of Research Jeff DeMaso said in our recent webinar,  Booster Shots, Market Shocks and the End of Fed Intervention:*

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Jeff DeMaso:

The debt ceiling is critical but confusing…and stakes are high. Each year Congress passes a budget dictating how much the government must spend. The U.S. government then has two ways of paying for that spending—taxes or borrowing money by issuing debt. Now, in addition to telling the government how much to spend, Congress also limits how much the government can borrow. That’s what the debt ceiling is: The limit of how much the government can borrow. The bottom line is that the government can potentially run out of money and default on its obligations if the debt ceiling isn’t raised.

Playing chicken with the debt ceiling has become a common tactic in politics, and the Treasury tries to buy Congress time to solve that problem. They extend the road, giving Congress more time to avoid defaulting on the government’s debt. They do this by shutting down parts of the government to rein in costs a little bit. A government shutdown isn’t anything new—and simply put, it’s not a good reason to avoid investing in the stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. market.

The worst decline that came during a government shutdown was around 4%—and that was in the 1970s. If we look at the five most recent shutdowns, stocks gained ground each time; in fact, during the December 2018–January 2019 shutdown, stocks were up over 10%. That’s a pretty good return.

Now, maybe it’s not a government shutdown but the prospect of the government defaulting that has you spooked. I think a default is a very low-probability event. And fortunately, we don’t have an instance of the U.S. government defaulting to look back on; the closest thing we have is a downgrade.

In 2011, Standard and Poor’s downgraded U.S. Treasurys from a AAA rating to a AA rating. Why did they do that? They were concerned about the debt ceiling and said, “Hey, we’re going to review U.S. debt and put it on negative credit watch.” They downgraded the U.S. debt, and you can see that stocks declined in and around that time. That said, the decline didn’t even reach 20%, so it was relatively shallow and the whole episode only lasted nine months or so.

It’s worth remembering that in 2011 there were serious concerns about European debt. This was the “PIIGS” European debt crisis of Portugal, Italy, Ireland, Greece and Spain. They were in the hot seat, so sovereign debt was in the headlines all the time.

How did U.S. Treasurys perform during this period of trouble and concern? Investors still flocked to them. U.S. Treasurys went up while U.S. Treasurys were being downgraded.

The point is that we’re going to hear a lot more about the debt ceiling in the weeks and months to come. Congress only extended funding for the government through early December, but don’t let this keep you from following your long-term investment plan.

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