March 1, 2023
The U.S. government hit its $31.4 trillion debt limit in January, setting the clock ticking on what could be a contentious debate over raising the debt ceiling.
Although markets have largely ignored the issue to date, rising concerns over whether a deeply divided Congress can raise the cap before the “X-date”– when the government runs out of funds – is important for investors to monitor.
This year’s debate will be intensified by signs that the federal government’s fiscal condition is rapidly deteriorating, partly due to higher inflation and rate hikes. It’s also possible the debate will put the federal government on a path to greater austerity, which may have longer-term implications for spending, taxes, industry sectors, and the economy.
Here’s what our public policy and market experts think may happen this time.
The Congressional Budget Office (CBO) has projected the government could default somewhere between July and September, or even as early as June if April’s tax receipts are lower than expected.1 Knowing precisely when the X-date falls will give investors a better idea of when volatility could intensify.
We think the debate may resemble much of what we saw in 2011, when Congress was also gridlocked and Republicans demanded spending cuts after the financial crisis. Back then, volatility started ramping up about a month before the August 2 X-date. If this year's tax receipts disappoint and history repeats, we could see default concerns affecting markets as early as May.
It took a plunge in equities, a 200% spike in market volatility2 and the first-ever downgrade of the government’s credit rating by Standard & Poor’s before a deal was signed in 2011, just days before default.
Exhibit 1: Market Volatility was Extreme but Short-Lived in 2011
Today’s political and fiscal backdrop is even more complicated than it was in 2011, so we may need the imminent threat of default to get an agreement.
Republicans today have a thinner majority in the House compared with 2011, and within the party a group of conservatives are pushing for spending cuts, including non-discretionary items like Medicare, in return for increasing the debt limit. At the other end of the spectrum is the Biden administration, which wants a clean increase in the cap with no strings attached.
The demand for spending cuts will undoubtedly be fueled by a recent $426 billion increase in the CBO’s projections for the fiscal 2023 budget deficit, to $1.4 trillion.3 Unlike 2011, we now have inflation and rate hikes rapidly adding to the budget deficit. Net interest outlays for fiscal 2023 have increased 42% since last May to $181 billion,4 while inflation has pushed up the cost of social security and other programs.
The CBO forecast adds $1.7 trillion of net interest costs to the budget over the next decade, 20% more than its projection in May last year. It sees Treasury debt climbing to $46 trillion and total national debt reaching $52 trillion by 2033.
Debt costs as a percentage of tax revenues are projected to average 16.8% over the next 10 years, much higher than the 6-7% range in the past decade. Some research suggests that once interest costs exceed 14% of revenues, financial markets begin to force austerity on policymakers.5
Exhibit 2: Federal Net Interest Costs are Projected to Soar
Headlines about the debt ceiling are likely to contribute to stock market volatility, but not until we get closer to the X-date. In 2011, the S&P 500 declined by roughly 17% in just over four weeks between July 7 and August 8, and the greatest underperformance was in sectors most vulnerable to spending cuts, such as defense, healthcare, and information technology.
Investors became increasingly defensive as the debate dragged on and started favoring recession-resilient sectors like utilities and staples over cyclicals.
It’s hard to draw direct comparisons between 2011 and 2023, because we don’t know what spending cuts or other fiscal reforms will arise from this year’s debate.
Yet we’ve seen from past debates that volatility is usually short-lived and can potentially create sector and stock-specific opportunities during market dislocations.
The MOVE Index, which measures volatility in the Treasury market, was just as volatile in 2011 as equities, with bonds reacting violently to Standard & Poor’s downgrade of U.S. credit to AA+ from AAA.
Volatility first appeared in three and six-month Treasury bills, where yields spiked as investors shifted out of securities maturing around 2011's X-date. We are watching that part of the Treasury market for any kinks in the yield curve, and we may shift out of bills and into high quality global bank CDs if Treasury bills begin to sell off.
A protracted debate also raises the risk that global investors will lose confidence in Congress’s ability to manage the U.S.’s growing deficit problems. The U.K.’s financial crisis in 2022 demonstrated how quickly investors will abandon a sovereign bond market if they think proposed legislation is fiscally irresponsible.
The government is taking "extraordinary measures" to raise cash reserves, and it will prioritize payments as the X-date looms, to ensure its debt servicing costs are covered until Congress raises the debt limit.
Ideally, Congress will forge a path to raising the limit without inciting fears of default. But given the complexities of today’s political environment, it's possible that like 2011, the debate will go down to the wire. While market volatility may be short-lived, we still recommend diversification within and across market sectors, to protect against market swings.
Investors will be best served by sticking to their long-term investment plans while using active management to take advantage of undervalued securities as the debate progresses.
1 Congressional Budget Office. “Federal Debt and Statutory Limit, February 2023.”
2 BNY Mellon Wealth Management Capital Markets Solutions. The CBOE “VIX” index rose over 200% between July 7, 2011, and August 8, 2011, when the S&P 500 fell 17%.
3 Congressional Budget Office. “The Budget and Economic Outlook: 2023 to 2033.”
5 Strategas. Policy Outlook, Feb. 16, 2023.
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