Should Investors Care About The Debt Ceiling Drama?

Summary:

Should Investors Care About The Debt Ceiling Drama?

It seems like every so often Washington likes to remind us how dysfunctional it can be, but then at the 11th hour, Washington eventually does what everyone thought it would do in the first place. The current dysfunction is the ongoing debt ceiling debate or how much Washington is able to borrow to keep paying its bills. It seems like we have this debate every few years, and in the end, a deal gets done at the 11th hour. So in this edition of the LPL Street View, we look at the ongoing debt ceiling kerfuffle and why we think investors should fade the noise. At the time of this recording, there's still no deal in place to either lift or suspend the debt ceiling. Both parties are expressing optimism that a deal will get done in time and both parties are adamant that the U.S. will not default on its debts.

More on this in a minute, but what's the hold up? The real points of contention seems to be which spending baseline to use for next year's discretionary spending, which represents only about 25% of the federal budget. Republicans want to use the 2022 spending baseline for next year, which would represent spending reductions of say, $130 billion, while Democrats have offered to freeze in spending at 2023 levels. The second contention is the duration and depth of the spending caps for how long and for how much does the growth of discretionary spending slow. Remember, we're talking about slowing the pace of spending not outright cuts, so the impact of the economic growth is likely to be minimal. The Treasury Department has said it will run out of cash on June 1, but that depends on spending in incoming tax receipts, which is why the actual date is referred to as the X date, and it's currently operating cash balance is around $76 billion.

For context, the Treasury's cash account got down to $11 billion in 2011, but there is a large social security payment scheduled for early June, which would likely draw the Treasury's balance to very low levels. While it seems like both parties are making progress and negotiations are ongoing, the clock is ticking. So how should investors think about the debt ceiling drama after years of waiting for cash to be a viable asset class? Again, investors have flocked into money market funds to take advantage of higher Treasury yields. In fact, with over $5 trillion in assets, money market assets under management have never been higher. However, with the ongoing debt ceiling drama in Washington, investors may be concerned about the prospects of delayed payment on Treasury bills, which generally make up a sizable allocation within certain money market funds. Aggregate data shows that money market fund managers are taking the potential of delayed payment seriously and have been positioning portfolios defensively.

Many not all managers have been utilizing the Federal Reserve’s overnight reversed repo facility, which is just a way to safely park cash outside of the Treasury market, but they're also selectively adding T-bills that mature outside of the X date. In particular, according to JP Morgan, money market funds kept investments in T-bills maturing in June through August, relatively low. Now, anecdotally, we see this in the 4% difference in yields between bills that mature on May 30 and those bills that mature on June 8, as investors are demanding additional compensation for the risk of delayed payment. In fact, the Treasury bill market is assuming the X date could be anytime within the first few weeks of June as those securities are trading at very wide discounts to par. To be clear though, if you own a Treasury bill that is set to mature after the X date and no deal is in place, the U.S. government will pay that bill back at par eventually.

It's the timing of that payment that's in question, not if it can make that payment. Once the debt ceiling is lifted, the U.S. government will make that payment, which is why we think outright default is very unlikely. So, investors owning T-bills will be made whole eventually, but because of the defensive positioning of money market funds, we do not think investor cash allocations are at risk. The equity market has not really reacted, which is consistent with history when it effectively ignores the drama until a few weeks or in some cases the week before the X date. As shown on this chart, the last four times of serious brinksmanship over the debt ceiling, the average peak to trough equity market return in the 30 days before the resolution was about a 7% loss. But in general, there's a relatively quick rebound of risk assets after the debt ceiling is resolved.

With the exception of 2011, when other factors were present, including the European debt crisis and investors pricing in a higher chance of recession, the U.S. rates market usually moves as well with the 10-year typically rallying 0.2% the week before the X date, which is somewhat ironic given the risk of the U.S. not paying its bills on time. But in general, for equity investors, the debt ceiling drama was met with a collective shrug, which we think is likely the case this time around as well. U.S. bond market investors have taken for granted the government's ability and willingness to pay its debt, while its ability to repay its obligations is not in question. The debt ceiling complicates the country's willingness to pay its debt, but the U.S. will not default. No one wins politically if the country defaults on its debt. Once the debt ceiling is resolved, Congress will pay all of its obligations and we think ultimately, like it has done 78 other times since 1960, Congress will raise the debt ceiling, but likely not until the 11th hour, which could give the market some heartburn in the interim. While the ongoing debate makes for good political theater, it's just noise in our opinion, and investors would be wise to look through the debt ceiling drama, and focus on long-term objectives instead. Thanks for listening.

Please continue to follow LPL Research on Twitter, LinkedIn, and YouTube for more insight.

You may also be interested in:

• Top Charts as Fed Recalibrates: Key Takeaways for Investors – May 9, 2023
• Cash Is Back, but Beware of the Risks – April 13, 2023
• Our Base-Case Assessment on Recent Bank Failures – March 16, 2023