On Borrowed Time

Hey everyone,

Lately, traditional markets have been one big snoozefest.

From a technical standpoint, they continue to consolidate, oscillating within a defined range. 

The U.S. Dollar Index (DXY), after weeks of consolidation, has bounced off its critical weekly low and is meandering towards its key weekly high.

Meanwhile, the S&P 500 has shown similar behaviour, persistently hovering below the crucial 4,200 level.

And fundamentally, the drama of climbing interest rates, stubborn inflation, and banking crashes feels like old news. In fact, markets have easily shrugged these seemingly disastrous events off, showing a few signs of capitulation but maintaining an odd resiliency.

The funny thing about doom-and-gloom events in the market is that when they’re happening, it always feels like a crash could be a day away. But when the doom-and-gloom never actually arrives, the market tends to chug along.

And so, that’s where we find ourselves today. Without any actual doom-and-gloom events to worry about, the market is up in arms about the U.S. Debt Ceiling, with Judgement Day marked for Thursday, June 1st, otherwise known as the ‘X Date’.

The ‘X Date’ is when, as Janet Yellen, the U.S. Treasury Secretary, casually points out, the U.S. might just run out of money to pay its bills.

We’ve written in the past that this would be calamitous; it doesn’t take a professional macroeconomist to know this. But it’s crucial to distinguish between the hysteria in the media and the reality of the situation.

To do that, we’re going to tear the topic of the debt ceiling apart – its origins, implications, historical dramas, and the current game of chicken in Congress.

So, let’s get into it and figure out whether we’re standing at the edge of the financial cliff without our bungee.

On Borrowed Time

As an investor, you might have heard about the concept of the U.S. Debt Ceiling before. For an outsider, this term may seem abstract. Still, its implications affect global markets and, indeed, the lives of U.S. citizens to some extent.

The Debt Ceiling (or Debt Limit as it’s sometimes referred to) is a legislative limit on the national debt that can be issued by the U.S. Treasury. It was institutionalized in 1917 under the Second Liberty Bond Act.

Essentially, it’s the financial ‘cap’ on the federal government’s ability to borrow money for fulfilling its existing obligations. For context, the national debt in the U.S. currently clocks in at $31.4 trillion (with a ‘T’), with the cost of servicing that debt (interest) amounting to $725 billion. These are not small numbers.

Contrary to popular belief, the debt ceiling isn’t an expenditure control measure but a borrowing control mechanism. The process of determining government spending (the budget process) and the one controlling borrowing (the debt ceiling) are different, causing both decision-making processes to be a regular subject of political contention.

So, what happens when U.S. debt hits the limit?

Basically, the Treasury can’t issue new debt, leading to a gap in the budget as the government continues incurring expenditures. 

To make it easy to understand, think of the U.S. government as any other business - one that has income, expenses, assets and liabilities.

The government earns income through taxes and has expenses that it pays like Social Security, Medicare benefits, military salaries and interest on their debt.

Usually, governments have to spend more than they earn. And this is generally okay in economics because governments don’t operate like regular businesses. Instead, they serve the public and aren’t meant to make a “profit.” But, without digressing, the concept of governments overspending and taking on too much debt is not necessarily good. It’s a hotly debated topic, especially for the U.S. today. 

When the government’s expenses exceed its income, that gap is called the budget deficit ($1 trillion in 2022). Those expenses still need to be paid, so the government funds them through national debt by issuing Treasury Bonds to investors in the market.

And so, that pile of national debt that the government takes on is capped by the limit. Each time the national debt hits the limit, the decision to increase it is taken to a vote by Congress, making it a political matter. This is done so the government can borrow more to meet its obligations.

The U.S. debt ceiling might start to feel like a relic from an ancient era the more you understand it. You see, with the continuous growth of the U.S. economy, inevitably, government spending will also increase. 

Let's put things into perspective. From 1900 to 2012, federal government receipts grew from 3% to 16.5% of GDP, while federal expenditures skyrocketed from 2.7% to 24%. The big picture? An expanding economy naturally calls for increased government spending. And as time goes by, that expansion will inevitably need to be funded by a growing mountain of debt unless the government can increase its income as fast. 

And here's the kicker: the increase in the debt limit needed to finance government spending (that's already been voted on) has to be voted on and approved again.

Sounds like we're going around in circles, doesn't it?

It’s like you're a credit card holder who goes over your credit limit. Sounds normal, but the twist is that only after you've made the purchases and racked up the debt do you decide to raise your credit limit. That's the debt ceiling process. 

Funny enough, the U.S. already hit the debt ceiling in January this year, but through some creative accounting techniques (called “extraordinary measures” by officials), they've managed to move enough money around to get by until now.

And here we are today, a week away from the (unlikely) possibility that the U.S. runs out of money to pay its bills, i.e. default.

A default hasn't ever happened, but if it did, it would send shockwaves through the global economic system. 

A default could precipitate a financial crisis because of the dollar’s central role in global finances, amongst other market derailments.

Although we'd give the probability of default less than 5%, let's dig into the implications if it happened. 

Ripple Effect on Markets 

The very foundation of financial markets is built on trust. A default would erode this trust, leading to higher interest rates, lower stock prices, and possibly a contraction in economic activity. In addition, doubts about the safety of U.S. government bonds would spread among domestic and international investors.

Doomsayers estimate that the $24 trillion market for Treasury bonds would be crippled, and stock markets could see drawdowns of as much as 50% if the U.S. defaulted. A fall like this would wipe out vast amounts of wealth, affecting investors from large institutions to everyday pension holders.

Increased interest rates would undoubtedly make borrowing costlier for businesses and consumers, slowing down investment and consumption and leading to a recession. 

While that is our worst-case scenario, it seems unlikely to play out this way. Looking to history instead could give us a good indication of how today's “crisis” may play out.

Lessons from 2011 

The 2011 debt ceiling crisis highlights the risks of political brinkmanship over the debt limit. Even though Congress eventually raised the debt limit, the delay resulted in Standard & Poor’s (S&P) downgrading the U.S.’s credit rating for the first time. In addition, the political uncertainty caused significant stock market volatility, with the S&P 500 crashing ~7% in a single day after the downgrade.

The Budget Control Act was passed in the aftermath of this standoff, leading to sweeping budget cuts, which forced many federal agencies to cut back on services, snowballing into job losses and reduced economic activity.

Although that sounds bad, there was no global financial collapse that followed 2011's debt ceiling debacle.

Interestingly, the remedy to the political tension we're seeing today around the debt ceiling may require a similar deal to be drawn up between the Republican and Democrat parties ahead of the June 1st deadline.

With President Biden and the Democrat party wanting to increase taxes to plug the government's deficit versus Kevin McCarthy and the Republican party advocating for deep spending cuts, both parties remain “far apart”, and tensions remain high.

Although it's been reported today that negotiators are moving closer to a deal to raise the debt ceiling while capping spending, nothing has been confirmed yet.

Political Games

The above points highlight the debt ceiling's use as a political weapon. 

Unfortunately, as the Republicans and Democrats have become increasingly polarised, they will use any means to push their policies.

The debt ceiling is the perfect tool, with a deal between the two parties needing to be made before a vote is passed in Congress to raise the limit. So, naturally, each party comes with its own laundry list of demands, unwilling to compromise.

And this is where the extremist voices of each party come to the forefront. This is where you get Donald Trump telling the Republicans to force a default if the Democrats don't meet their demands. While the extremist Democrats fearmonger, saying that the Republicans are causing ordinary Americans to lose their livelihoods by forcing a default.

All these campaign games by politicians bring to mind a quote from Charlie Munger:

Applying this to each party’s incentives, we can see that default will not happen. President Biden's motivation to win re-election in 2024 would never allow him to let his country default, most likely leading to a more generous compromise to the Republican's demands in the deal that gets done. In the same breath, the Republicans must avoid being painted as the “villain” of this theatrical act to remain in good faith going into the next election cycle.

So, while the mainstream media will fearmonger and overhype the debt ceiling crisis to generate clicks and politicians advocate for their policies, no one close to this decision can afford to let a default happen. The reputational damage would be far too significant.

However, despite the familiar pattern of political brinkmanship in today's negotiations, the financial world still holds its breath:

• Treasury yields have remained high for very short-term maturities, with the June 1st bond yielding 6.9% (reflecting an increased risk in U.S. Treasury bonds).

• And, concerningly, Fitch (another notable credit-rating agency) has put the U.S. on credit watch since no deal is in sight.

Is There a Solution?

While the current negotiations will probably end in an 11th-hour increase to the debt ceiling, it’s clear that this issue is not going away. With the government having raised the debt ceiling 78 times before, the frequency and intensity of these standoffs have led many experts to call for a rethink of how the U.S. handles its national debt.

• Some advocate for abolishing the debt ceiling, arguing that it’s more a tool for political leverage than a valuable mechanism for controlling national debt.

• Others propose that the debt ceiling should automatically increase with each budget approved by Congress, ensuring the government has the means to fulfill its budgetary obligations at all times.

• And another body of thought argues that the real issue is not the debt ceiling but U.S. spending habits. They assert that serious conversations need to happen about the country’s spending and taxation policies, which are the root causes of the increasing national debt.

While those are neither here nor there, there's a more straightforward solution - the U.S.’ debt problems would be solved if GDP growth doubled to 4%. At that growth rate, debt-to-GDP would be stable, even without the proposed spending cuts.

The bottom line is that innovation matters most for U.S. economic growth. In other words, new technologies need to be deployed to the masses to increase productivity (AI, you’re up!). However, what accelerates that is not macro but microeconomics, calling for a departure from the political theatre we’re seeing in Washington.

That, coupled with some of Ray Dalio's “bipartisan moderate politicians who are willing to fight for what is right”, could set the U.S. on a sustainable future and waste less time on political shenanigans.

And that is precisely what this whole debt ceiling drama is - it's nothing more than clever shenanigans manufactured to spook investors into believing the markets are teetering on the brink. But if we take a closer look, we'll see that the savvy investors among us aren't flinching nor changing their investment strategies or portfolios in the face of this political spectacle.

From Pomp to Ray Dalio - we're holding our ground, and we suggest you do the same.

Let's be honest here. The decisions being made are far from public scrutiny - they're confined to the hushed corridors of power, where politicians hash out the final decisions - beyond our sight and our control.

However, it's still essential to stay aware of these events — analyze them, understand their implications, and see how they fit into your investment worldview. If your data starts showing deviations from what you expect, then take action. But if the ship stays on course, hold the line and continue doing what's within your sphere of influence.

Hopefully, we've convinced you that this debt ceiling problem is no more than an apparition. This is not to say that the fallout won't be nasty if things go south — they indeed could.

But what are the odds of that happening? They're slimmer than you might think.

Thanks for reading. Share this with a friend if you found it insightful.

— Luca