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Investment Strategy

Debt ceiling: Déjà vu?

Apr 21, 2023

With the government up against its spending limit, negotiations are brewing in Congress. Investors’ best move now? Stay the course.

Chris Seter, Global Fixed Income Strategist

Olivia Schwern, Global Investment Strategist
 

Our Top Market Takeaways for April 21, 2023

Market update

So far, so good

Investor focus has shifted from banks to corporate earnings and economic data. And so far, companies are proving more resilient than expected, despite signs pointing to a slowing U.S. economy.

Most notably, the too-hot labor market is showing early signs of easing up. The number of continuing unemployment claims reached the highest level in nearly two years. The housing market is also working hard to find its footing. The NAHB Housing Market Index, a survey of homebuilders for new homes, hit its highest level since September and is in its fourth straight month of increases. But extremely low inventories are keeping existing home sales at a trough-like level.

Global growth is also still solid. The Global Purchasing Managers’ Index has bounced from last fall. China is in the early stages of its reopening, with economic growth now running at its fastest pace in four quarters. Europe is benefiting from the pent-up demand, and even EM export data is exceeding expectations by the most in two years.

Markets had a hard time finding direction along the way. Heading into Friday, the S&P 500 looks to finish the week just slightly off of where it started (~4,130), and bond yields took a round trip on both hot and cold data. But despite a mixed week, stocks have now gone 20 straight trading days without falling at least 1%, the longest streak in nearly two years. Implied equity volatility has collapsed to its lowest levels since the Federal Reserve started hiking.  

The path from here will likely hinge on the rest of earnings season (a busier next week) and word from the Fed at its meeting in the first days of May.  

In the meantime, it’s been close to four months since the U.S. government hit its debt limit, and the saga has floated back to the surface. In the rest of today’s note, we revisit what we know and what we’ve learned out of Washington over the past week.

Spotlight

Guess who’s back, back again: Debt ceiling drama
 

At the start of the year, the U.S. government hit its legal $31.4 trillion debt limit. We published a note at the time that walked through the fundamentals of the debt ceiling, what happens when the government approaches these levels, and what investors have experienced in past Washington showdowns. Over the last few months, the Treasury (which is responsible for the government’s pocketbook) has been hard at work using “extraordinary measures” to help the government continue paying its obligations and avoid default. But those measures can only last so long.

The background:

Some form of a cap on government debt has been in place since 1917, and an event such as this is far from uncommon. If Congress fails to suspend or raise the limit by the potential default date, also known as the “X-date,” we would expect the Treasury to prioritize paying its debt obligations, while curbing other expenditures such as education and transportation, or more even drastically, Social Security. If the Treasury then fails to make payments on its obligations (worst case), the impact could be calamitous—a reason to expect that a compromise among policymakers would eventually be found.

A recent history of the U.S. debt ceiling

Source: Bloomberg Finance L.P., J.P. Morgan. Data as of April 20, 2023.
The chart describes total Treasury debt in a line format, and the history of the debt ceiling since January 1992 until now in a flat lines format. Shaded bars represent times when the debt ceiling was suspended. The unit is in trillion $. For total Treasury debt, the first data came in at 3.7 trillion in January 1992. It steadily rose until it hit 5.6 trillion in May 2001. Then it went on a faster rise until it reached 9.5 trillion in June 2008. Then it accelerated further until the latest data point at 31.5 in March 2023. For debt ceiling and suspension, the first debt ceiling came in at 4.1 trillion in January 1992. It lasted until March 1993. Then the debt ceiling was raised to 4.4 trillion in April 1993 and lasted until July 1993. Then the debt ceiling was raised to 4.9 trillion in August 1993 and lasted until February 1996. Then the debt ceiling was raised to 5.5 trillion in March 1996 and lasted until July 1997. Then the debt ceiling was raised to 6.0 trillion in August 1997 and lasted until May 2002. Then the debt ceiling was raised to 6.4 trillion in June 2002 and lasted until May 2003. Then the debt ceiling was raised to 7.4 trillion in June 2003 and lasted until November 2004. Then the debt ceiling was raised to 8.1 trillion in December 2004 and lasted until March 2006. Then the debt ceiling was raised to 9.0 trillion in April 2006 and lasted until September 2007. Then the debt ceiling was raised to 9.8 trillion in October 2007 and lasted until May 2008. Then the debt ceiling was raised to 10.6 trillion in June 2008 and lasted until September 2008. Then the debt ceiling was raised to 11.3 trillion in October 2008 and lasted until February 2009. Then the debt ceiling was raised to 12.1 trillion in March 2009 and lasted until December 2009. Then the debt ceiling was raised to 12.4 trillion in January 2010 and lasted until February 2010. Then the debt ceiling was raised to 14.3 trillion in March 2010 and lasted until January 2012. Then the debt ceiling was raised to 16.4 trillion in February 2012 and lasted until January 2013, when the debt ceiling was breached and suspended. Suspension went from February 2013 to May 2013. Suspension ended, and the debt ceiling was raised to 16.7 trillion in June 2013 and lasted until October 2013, when the debt ceiling was breached and suspended. Suspension went from November 2013 to January 2014. Suspension ended, and the debt ceiling was raised to 17.2 trillion in February 2014 and lasted until March 2015. Then the debt ceiling was raised to 18.1 trillion in April 2015 until October 2015, when the debt ceiling was breached and suspended. Suspension went from November 2015 to February 2017. Suspension ended, and the debt ceiling was raised to 20.0 trillion in March 2017 and lasted until September 2017, when the debt ceiling was breached and suspended. Suspension went from October 2017 to February 2019. Suspension ended, and the debt ceiling was raised to 22.0 trillion in March 2019 and lasted until July 2019, when the debt ceiling was breached and suspended. Suspension went from August 2019 to July 2021. Suspension ended, and the debt ceiling was raised to 28.5 trillion in August 2021 and lasted until October 2021. Then the debt ceiling was raised to 28.9 trillion in November 2021 and lasted until December 2021. Then the debt ceiling was raised to 31.4 trillion in January 2022 and lasted until March 2023.

In the long history of the debt limit, the impasse in 2011 carries the most notoriety. Congress increased the ceiling just before the X-date, the closest call on record. Days later, the S&P downgraded the government’s credit rating to AA+ from AAA. Risk assets reacted negatively: The dollar sold off, stocks sank and credit spreads widened, but a strong rally in Treasuries led bonds higher overall. Outside of this instance, markets have been more driven by the prevailing economic and market dynamics of the time, and volatility has been ultimately short-lived.

The takeaway:

The U.S. government has approached and exceeded the debt limit dozens of times throughout history, and in each instance, policymakers have eventually come to a compromise to raise the ceiling and avoid the worst-case scenarios. The best way for investors to prepare for potential disorder is by simply sticking with their long-term portfolio plans that are built to weather events such as these.

What’s ahead:

Negotiations in Congress are starting. Republicans detailed their stance this week. The bill has not yet been finalized, though House Speaker McCarthy came out with a proposal for a $4.5 trillion reduction in budget deficits over the next decade in exchange for a temporary suspension of the limit through March 2024, or a $1.5 trillion increase. The details include a significant reduction to non-defense discretionary spending, a reversal of student debt cancellation, a return of unused pandemic funds and more.  

Even if the bill is passed in the House after it’s ironed out (an uncertain outcome, given a slim majority and fractured caucus), the proposal will likely be a non-starter for Democrats. Negotiations look set to go down to the wire.

Tax revenues will soon provide clarity on the potential default date. The second catalyst of this week was Tax Day on April 18. Tax revenue data will soon allow investors to better pinpoint the runway to the X-date. For now, this timing is widely estimated to fall between June and August (with bias on the earlier side due to weak receipts so far), but we expect estimates to shift in the coming days.

We see three scenarios on how this could play out. We think the first is the most likely:

(1)  The debt ceiling is increased ahead of the potential default date. In every instance in history, this has been the eventual outcome, and we expect this year to be no different. As Congress works out a compromise, we’re likely to see investors avoid Treasury bills that mature in the wake of the X-date. This has already started to play out as 3-month Treasury bill yields have spiked and 1-month Treasury bill yields have plummeted to their lowest level since last October. In fact, the dispersion between the two is the widest in over 20 years. We expect these oddities to continue as policymakers work out the kinks to reassure investors of the soundness of short-term government debt.

The risk of a U.S. default pushed T-bill yields in different directions

Source: Bloomberg Finance L.P., J.P. Morgan. Data as of April 20, 2023.
The chart describes 1-month and 3-month Treasury bill yields on two lines. Diamond signs are used to represent the most recent data point (3.3% for 1-month Treasury bill yield and 5.1% for 3-month Treasury bill yield) in April 2023. The unit is %. For the 1-month Treasury bill yield line, it started at 0% in May 2015. It trended up until it peaked at 2.4% in April 2019. Then it slowly fell to 1.5% in January 2020. Then it dropped to -0.02% in March 2020. It stayed near 0% until it reached 0.01% in February 2022. Then it went up all the way until it reached 4.6% in March 2023. Lastly, it dropped to the most recent point at 3.3% in April 2023. For the 3-month Treasury bill yield line, it started at 0% in May 2015. It trended up until it peaked at 2.4% in March 2019. Then it slowly fell to 1.3% in February 2020. Then it dropped all the way to -0.04% in March 2020. It stayed near 0% until it reached 0.1% in January 2022. Then it went up all the way until it reached 4.9% in March 2023. Then it slightly dropped to 4.3%, also in March 2023. Lastly, it rose to a new high at 5.1% in April 2023.

(2)  We go through the X-date without a ceiling increase, but the Treasury still makes interest payments to avoid a technical default. In our view, to avoid default, the government would prioritize security payments at the expense of cuts to discretionary, or even mandatory, spending. The consequence of this is a direct hit to economic activity and financial market sentiment. Other ways to avoid default would be to simply ignore the debt limit on grounds that it violates the 14th Amendment (which would cause serious legal trouble), or the Treasury could mint a coin and deposit it to the Fed—the latter being, to us, highly farfetched.

(3)  We go through the X-date and delay payments (i.e., default). This would be the worst-case and least likely scenario. It’s hard to say what the full consequences would be, but it’s likely the harsh reaction across financial assets would warrant movement from Congress. But even if the debt limit is subsequently raised, the question remains on whether Treasuries would need to trade with a permanently increased risk premium (i.e., investors would demand to be compensated more for taking on greater risk). The “risk-free” rate would be a term of the past.

Investment implications

Diversification is still the best defense
 

The potential for a disorderly debt ceiling episode provides another opportunity for global investors to reconsider their portfolio allocations across asset classes and regions.

Further, yields globally are still near recent highs, with bonds outside of the United States also providing compelling income and protection in the event of a broad economic downturn. Finally, while stocks could take a hit in an adverse scenario, high-quality international equities are being supported by a resilient global growth story and could provide relative insulation. For the more tactical investor, safe-haven currencies like the Japanese yen and Swiss franc, as well as precious metals such as gold, could provide some protection.

And for those sitting on excess cash, debt ceiling turbulence could be a good thing to watch for a potential entry point.

All told, debt ceiling episodes have come and subsequently gone in the past. While the last couple of years in markets have taught us to “never say never,” our base case is for an agreement before the default date is breached. The most powerful tool in investors’ toolkits is simply sticking with the long-term investment plan that was set up to weather events such as these.

Your J.P. Morgan team is here to help you put this into the context of your and your family’s portfolio.

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All market and economic data as of April 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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