Investing with Debt Ceiling Uncertainty

Telemus Weekly Market Review January 9th - January 13th, 2023

This past week, Treasury Secretary Janet Yellen sent a letter to House Speaker Kevin McCarthy as well as other congressional leaders stating that she expects the Federal government to reach its debt ceiling this coming Thursday. At that point she plans to use so called extraordinary measures, such as deferring the funding of government pension plans, to manage the Treasury’s cash flow until congress raises the debt ceiling. She expects that these extraordinary measures will allow the federal government to fund operations into June, at which point the Treasury may run out of levers to pull and could default on its obligations. 

Hitting the debt ceiling and using extraordinary measures to manage cash flows has become common. At this point Wall Street seems to shrug its shoulders when the debt ceiling is reached and focuses more on when extraordinary measures are expected to run out. More recently the U.S. hit its debt ceiling in 2011, 2013 and in 2021. In order to provide more color on how markets may react should congressional debate around the debt ceiling continue, we examined these recent episodes. 

During 2011, the debt ceiling was hit on May 16th with concerns around continued deficit spending striking contentious debate in the halls of congress. At the time, Treasury Secretary Tim Geithner estimated extraordinary measures would run out around August 2nd. Congress ultimately struck a last-minute deal that President Obama signed on August 2, 2011. A ramification of congress stretching the credit worthiness of the U.S. to the brink was Standard & Poor’s August 5, 2011 downgrade of the U.S.’s credit rating from AAA to AA+. 

The 2013 episode had a similar feel and timeline to it. The debt ceiling as hit on June 28, 2013 with expectations that extraordinary measures would run out as early as mid-October. Congress ultimately passed a resolution to raise the debt ceiling on October 17, 2013. The ramification from this episode was the decision by a different debt rating agency, Fitch, to put the U.S. on watch, or an indication they were considering downgrading the credit rating of U.S. 

In 2021, the debt ceiling expired in August and ultimately reached a conclusion after four months of uncertainty leading with a December resolution. This time around there were no impacts to the credit rating of the U.S. government. 

Given the broader ramifications on the credit rating of the U.S., we focused our analysis on the 2011 and 2013 episodes. In both scenarios we noticed an uptick in market volatility in the time leading up to and following the debt ceiling being met. What was an interesting observation was that the market reaction to each episode was different.  After the debt ceiling was hit in 2011, gold and long dated bonds (i.e. 10-year Treasuries) held up well generating positive returns as flight to safety assets were favored. Stocks were down with investors electing not to discriminate between U.S. and non-U.S. shares. Following S&P’s downgrade of the U.S. debt to AA+, U.S. stocks rallied modestly, while gold sold off.  

The results in the 2013 debt ceiling encounter were nearly the inverse of 2011. International equities did well throughout the period, with the S&P 500 remaining positive after the debt ceiling expired and even rallied 10% between Fitch's October 15th decision and year end. The worst performer during that encounter was gold, which was modestly positive while a resolution was debated, but sold off sharply after the debt ceiling was raised. Long dated Treasuries were a drag on performance trending flat throughout the episode and for several months after.   

This analysis highlights that while the U.S. is likely to meet a debt ceiling again, the risk of altering portfolios to hedge or capitalize on any market reactions is in our view not worth the risk. First, markets move based on the combination of multiple factors. Thus, one can’t invest in isolation on a single factor, such as the debt ceiling. Second, timing decisions around political outcomes which themselves are impossible to time, adds unnecessary risk to portfolios. Even if we knew, for example, that flight to safety assets like gold and bonds would perform well following the debt ceiling being met, we may not know when to reverse those positions until after a deal was struck. Therefore, any benefit may be quickly unwound. Finally, what our analysis of 2011 and 2013 did demonstrate was the episodes appeared to be just short-term noise. Sure, markets moved a bit and asset prices did diverge. But six months after the episode, prices had reverted, and long-term investors were back on the same course they had been prior to the debt ceiling having been hit. 

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