Crises are always lurking in financial markets. I’m worrying about a possible recession, rising interest rates, rampant inflation and the continuing economic effects of the war in Ukraine and the Covid-19 pandemic, but I have been for months.
Now, it’s time to add to that list the threat of a catastrophic breach of the federal debt ceiling, which could conceivably come to pass sometime this summer. Even now, with the odds of an eventual crisis clearly rising, it is difficult to accept that it might really happen.
“Breaching the debt ceiling has always been unthinkable,” said Edward Yardeni, a veteran independent Wall Street economist. “Now, I’m afraid we’ve got to think about it.”
Thinking about it doesn’t mean panicking. Even in a crisis, I buy and hold diversified investments in the global stock and bond markets, preferably through low-cost index funds. That’s a well-tested approach for long-term investing. It makes sense as long as you are able to withstand market turbulence and hang on for decades.
But your risk tolerance will surely be tested later this year, if the government exhausts the capabilities of “the extraordinary measures” that the Treasurysays could begin on Thursday. Through these technical maneuvers, the Treasury is stretching out its cash reserves and delaying the moment of reckoning when the U.S. government runs out of the money needed to pay its bills. “The X date,” as it is being called — the absolute, no-kidding, deadline for the lifting of the current $31.4 trillion debt limit — is expected to arrive sometime in the second half of 2023.
Breaching the debt ceiling is entirely avoidable, of course. All Congress needs to do is increase the statutory limit on U.S. debt, and the problem will disappear.
But a wing of the Republican Party insists that cuts to government programs, including Social Security and Medicare, must be combined with increases in the debt limit. The deal that Representative Kevin McCarthy of California struck with holdout Republicans to gain the post of House speaker has raised the risks of an outcome that boggles the mind: a default on supposedly “risk-free” Treasury debt that could destabilize the global financial system.
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Virtually all financial assets on the planet are priced in relation to Treasuries, so you could argue that if the U.S. Treasury defaulted, there would be nowhere safe to go. The entire financial world would suddenly become much riskier, so it is difficult even to contemplate such an eventuality.
Bizarrely, since World War II, after every previous debt ceiling crisis — and, indeed, whenever markets have panicked — investors around the globe havetypically flocked to the U.S. Treasury market as a safe place to park their money.
In the long run, I think that is likely to happen again. Where else in the world can investors go for safety? For the immediate future, there are few, if any, better options.
But the debt ceiling has never been pierced before. If it really happens this time, it is impossible to know how dire the economic and market effects may be.
At a minimum, as an investor, you will want to be prepared, with ample cash holdings. You may want to move some money to the safest places, like government-insured bank accounts. Because a debt ceiling crisis could set off severe market declines for a while, it would be wise to soberly assess your ability to bear losses. If you know you can’t handle them, reduce the risks you are taking well before you start reading about imminent market disruptions.
Low Probability but High Risk
So far, the markets, have largely shrugged off these concerns as a remote possibility. Demand for Treasuries remains robust, and after months of declines last year, the stock market has been on an upward trend since the autumn. The markets seem to expect that the debt crisis won’t amount to much, and that could be correct.
After all, despite many contentious episodes over many decades, Congress has always raised the debt limit, and the United States has been able to borrow enough to pay its bills.Those actions have preserved the “full faith and credit of the United States,” and maintained, and even strengthened, the primacy of the dollar and of U.S. Treasury bonds in the global financial system.
Still, the markets have reacted negatively when Republicans in Congress used the debt ceiling as a weapon aimed at extracting concessions from Democrats in the White House and Congress. Some episodes have been ugly.
The two closest calls were in 1995 and 2011. First, in 1995, when Newt Gingrich was speaker of the House of Representatives, he threatened to send the United States into default, unless the Clinton administration slashed spending. And in 2011, under Speaker John A. Boehner, Republicans in the House demanded budget cuts from the Obama administration in exchange for their support to raise the debt limit.
That particular perils-of-Pauline crisis ultimately ended in compromise, but it was scary enough to lead Standard & Poor’s to downgrade its assessment of the previously pristine U.S. Treasury debt. Further downgrades can be expected this summer if there is a severe crisis. Borrowing costs throughout the economy would rise for a while — though markets have an amazing capacity to recover from shocks, and forget them, after remarkably short periods.
This time, Congress must not only raise the debt limit before it is reached, it also must renew government spending authority by Sept. 30 or set off a shutdown of all but the most essential parts of the government. Such shutdowns are damaging — to consumers, federal workers and investors — but they have happened many times, including in 1995, 2013, 2018 and 2019. Breaching the debt limit would be a far more dangerous event.
Coping With Disruption
Doug Spratley, who heads the cash management team at T. Rowe Price, said debt ceiling imbroglios have become so frequent in recent decades that he has a regular playbook that he will now start using again. “Every 18 months or two years, I seem to be doing something like this,” he said.
As the “X date” draws closer, he said, he will avoid holding Treasury securities that come due on that day and will make greater use of the resources of the Federal Reserve to keep his firm’s money market funds operating smoothly.
What’s more, even if the Treasury hits the debt ceiling, it is likely to have enough funds coming in to avoid a debt default for a while — though it would need to cut federal spending somewhere. And even in a brief, contained default of individual Treasury securities, Mr. Spratley said, money market funds will keep functioning, with one caveat: In a major panic, with mass selling of funds, “it will be a government problem, and the government will have to step in.”
A panic, however, is exactly what can happen if there is a Treasury default. Some money market funds froze up in the financial crisis of 2008, and bond funds came under pressure in the market panic near the start of the coronavirus pandemic in 2020. Both types of funds could easily be disrupted again.
I hold both, and consider them safe under the rules of the game as they have been played — until now. But if the debt crisis isn’t settled well before “the X date,” I expect to stash more money than usual in a federally insured high-yield online account at a reputable bank.
In a debt crisis, a panic in money market funds or the Treasury market would undoubtedly extend to other asset classes, especially the stock market. Plunging into stocks and bonds during a quick, major downturn takes guts, and I wouldn’t recommend that anyone who isn’t a professional trader try to time the market. The possibility that you will stumble into a disaster is high.
But unless you are convinced that the long-term growth of the world economy is over — and I don’t see why you should be — sticking with stocks and bonds despite the turmoil is likely to pay off eventually.
Conserve and protect your cash in a crisis. As always, make sure you can pay the bills. Then, let’s hope that in a decade or more from now, the debt ceiling problem of 2023 will look like an odd detour, one that we have put well behind us.