US Debt Ceiling: What it is and what it means for you

Once again, Congress and the White House are wrangling over an increase in the debt ceiling. The stakes are high. Failure to do so would lead to a default on the federal debt, which could have far-ranging economic consequences.

If history repeats, a deal will ultimately be reached. In the meantime, political uncertainty could disrupt financial markets—and also create investment opportunities. Says Lars Schuster, institutional portfolio manager in Fidelity’s Strategic Advisers group: “It’s unnerving to see these headlines. The good news is that historically volatility in the markets tends to be fairly short-lived. This could result in a good buying or portfolio rebalancing opportunity for long-term focused investors.”

What is the debt ceiling?

The federal debt ceiling is a limit set by Congress on the amount of money that the US Treasury can borrow to fund the government’s operations and make interest payments to the people and institutions who own US government-issued bonds. Since the ceiling was reached in January, the Treasury has relied on so-called extraordinary measures to keep operating until Congress reaches an agreement for a debt limit increase. If the debt ceiling is not raised, the Treasury would be unable to issue more Treasury securities and the nation could default on its debt, potentially by June.

Since 1985, the Treasury has had to resort to extraordinary measures 11 times and each time Congress has acted to forestall default, though often at the last minute after considerable high-stakes wrangling. Alice Joe, vice president for Federal Government Relations, says neither party in Congress views default as an option, but the highly partisan environment is making it harder to reach an agreement to extend the debt limit than has been the case in the past.

The possibility that the Treasury could run out of money may cause some short-term volatility in financial markets and the flurry of fear-inducing news stories that often accompany choppy markets. As the chart below shows, markets have historically risen on average in the months following an agreement to raise the debt ceiling.

The debt ceiling has, in the past, spurred contentious and prolonged debate about fiscal responsibility and the growing national debt.

In 2011, the disagreements went so far that the credit rating agency Standard & Poor’s downgraded the US credit rating to AA+, one step below the best rating of AAA. Standard & Poor’s cited the growing deficit and the prolonged debate as reasons for the downgrade.

Historically, raising the debt ceiling has not been a battle legislators want to fight. Administration officials usually work behind the scenes to convince legislators of the importance of raising the limit relatively quickly and without fanfare. This approach helps limit financial market uncertainty, minimizing the potential for government borrowing costs to increase amid a debt-ceiling debate, while reducing investor concerns.

What is the US national debt?

One thing separating today’s debt debate from those of the past is the larger-than-ever national debt. Publicly held US debt topped 120% of gross domestic product in the third quarter of 2022, according to the US Office of Management and Budget.

And the debt is projected to increase significantly in the future. The Congressional Budget Office (CBO) projects the federal budget deficit will total $13.1 trillion from 2023 through 2032.

What if the US debt ceiling is not raised?

Unless a deal is reached to suspend or raise the debt limit, the US will be in danger of defaulting on our national debt. There are some steps the Treasury is taking to forestall a default, including spending down saved cash and taking other emergency measures. But those extraordinary measures are expected to be exhausted by sometime in early June.

If all of the Treasury’s cash balances are drawn and extraordinary measures have been exhausted, the Treasury would be at the limit of the debt ceiling. Such an outcome has not occurred in the modern era, and it remains uncertain as to exactly what developments would transpire next.

However, if Congress still does not raise the debt ceiling, the US government would have to operate on a cash-flow basis, meaning that outflows (including interest payments on existing Treasury debt) would have to be funded by inflows (i.e., tax receipts and fees). Operating in this manner would require prioritization of payments, which could have several negative implications.

For one, this prioritization would place some counterparties in a subordinate position, which could unsettle the markets. For instance, during the debt debate in 2013 when the US was only days away from default, prioritization of payments was discussed as a possible option. While principal and interest payments could potentially continue to flow to bondholders, other payments like Social Security benefits could be suspended.

Also, the rating agencies would most likely place the sovereign rating of the United States under review and would potentially lower the rating if a debt-ceiling increase was not enacted. That could significantly increase the cost of borrowing at the national level.

Furthermore, critical functions to operate the government, including spending for military, Social Security, and other programs, would likely be interrupted, pressuring economic activity. Finally, the timing of tax collections is always uncertain, creating the potential for an inadvertent missed interest payment.

What happens if the US defaults on its debt?

An actual default is unlikely because of the reverberations that could be expected, including:

What can investors do about the debt ceiling?

It’s clearly in the best interest of the country to resolve any debt-ceiling issues.

Still, there will always be times of uncertainty. It’s important to take a long-term view of your investments and review them regularly to make sure they line up with your time frame for investing, risk tolerance, and financial situation. Ideally, your investment mix is one that offers the potential to meet your goals while also letting you rest easy at night.

The article is from Fidelity Viewpoints