The United States debt ceiling is a legislative restriction on the amount of national debt that can be issued by the Treasury to meet its existing legal obligations. What’s interesting about the debt ceiling, however, is that it does not actually restrict future spending.
Rather, the debt ceiling can only restrain the Treasury from paying expenses that have already been incurred, meaning the government may not be allowed to borrow more money but it can still continue to spend and increase its future liabilities.
The debt ceiling is not set in stone, and since 1960, Congress has acted 78 separate times to modify the debt ceiling in some way.
As a result, the implications of exceeding the debt ceiling are somewhat unknown, and many investors and the media have characterized a breach as an immediate default on the national debt. However, it’s a little more complicated than that and requires a brief explanation of how the Treasury operates.
Congress tells the Treasury to cut checks to entities it has promised to pay and collects taxes that Congress has told it to collect. Often times the amount of money that Congress has promised to pay exceeds the amount it collects through taxes, and the Treasury borrows money to cover the difference.
If we hit the debt ceiling, the Treasury would no longer be legally allowed to borrow any more money to fill this gap and three options would then exist:
1. Ignore: President Obama could order the Treasury to sell more bonds which would allow our government to continue to borrow and exceed the debt ceiling. Technically speaking, ignoring the debt ceiling is unconstitutional but may turn out to be his best option.
2. Prioritize: President Obama could instruct the Treasury to pay some of our creditors, particularly other countries, and then the most important bills here at home. However, there is much question as to how to prioritize payments and if systems are even capable of doing so at the Treasury.
3. Default: The U.S. would not have enough money to pay its current debt payments and default on its debt for the first time in our history. This option would be analogous to ordering a big meal at a high-end restaurant and then skipping out on the bill.
Current State of Affairs
Although we see the government shutdown as a buying opportunity on any dips, the debt ceiling is a more serious situation as even a threat of default will cause long-term interest rates to rise.
Back in May, the government hit its current $16.7 trillion debt ceiling and since then has been using emergency measures to conserve cash. Treasury Secretary Jack Lew recently told lawmakers that the government will not have enough cash on hand to meet our obligations as of October 17, and the nonpartisan Congressional Budget Office says the U.S. will start missing payments by the end of October unless Congress raises the ceiling.
A default could cause significant short-term disruption in financial markets across the world. Our debt is effectively considered to be free of default risk, and it”s difficult to speculate on the outcome of such a dramatic event given a default has never occurred.
However, we do not expect any changes to the long-term thesis for owning equities for two key reasons:
1. Politics: Neither party will emerge unscathed from a political storm caused by a default. Although we rarely attempt to analyze the outcome of government decisions, we believe that the implications of a default will force both sides to come to an agreement.
2. Nowhere Else To Go: Although interest rates would rise and volatility would pressure markets in the short-term, the U.S. is still the safest and most robust economy in the world with the most liquid financial system. Simply put, investors across the globe may be furious with the U.S., but where else are they going to go?
NOTE: It”s important to remember that although we believe the odds of a default are exceptionally low, we still put a great deal of time and effort into running scenario analyses to determine the impact to our portfolios if rates were to spike. In doing so, we are able to then determine if there is, in fact, any real risk to our long-run thesis for owning equities. Here we see very little impact over the long-run.
We have been taking steps to reduce interest rate exposure in our conservative portfolios over the past two years and continue to do so today. This week, we added positions to the DIAS Conservative Income (CI) portfolio that will profit from rising long-term interest rates and lessen the effects of any short-term issues arising from our government dysfunction.
Given the fact that we have believed for some time now that long-term interest rates would rise, a natural question would be to ask why we chose now to add these positions. To answer this question, let”s walk through our logic step-by-step:
1. We are very confident that long-term interest rates are positioned to rise over the coming years but the question of when rates will rise is a tougher question to answer (timing markets is extremely risky and we make few attempts to do so).
2. In the short-term, even the hint of a default would cause an immediate spike in interest rates (investors require a higher return to be compensated for the increased risk in an asset), and most interest rate sensitive assets, like bonds, would be negatively impacted.
3. Since we know when the debt ceiling and potential default will come to fruition, we can hedge interest rate exposure now without trying to time the market blindly.
4. If we do see a quick spike in long-term interest rates, then our hedge will protect us from some of the losses that may incur in our interest rate sensitive assets.
5. If we do not see any rise in rates or threat of default, we are still hedged as rates rise over the coming years (currently long-term rates are almost half of their historical average). Effectively our short-term hedge transforms into a longer-term one.
The bottom line is that although we feel that a default is extremely unlikely, we still have a contingency plan in the event that one does occur. Regardless of the outcome, we strongly believe that the direction for long-term interest rates and U.S. equities is higher, and we are positioned to profit accordingly.