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TAG Talks: A Guide to Debt Ceiling Negotiations

May 23, 2023

 

In this month’s market commentary, we’ll be discussing the current debt ceiling standoff. With more of a commentary touch on the political intrigue involved, we’ll cover the potential outcomes of whether or not we raise the debt ceiling before a default occurs. We believe this topic merits a discussion because the outcome has the  potential to drastically impact the health of the United States’ economy as well as our sovereign debt rating. Of course, the market and your investments are also connected to these outcomes. As we state time and again, it is our belief that people wanting financial success are typically wise to ride the gyrations of the world, as our portfolios are designed with an eye towards weathering any storms that may come our way. Each individual strategy we use is tailored to your specific needs, with potential risk a central fixture to our advice provided to you.

This newsletter was written on May 17th, and it is possible that specific newsworthy events have either confirmed or changed what we have said below. 

The Debt Ceiling and Circumstances of This Standoff

Way back in 1939 and 1941, the Public Debts Act was established which puts in place a congressionally approved debt limit. This means that the Federal government has the authority to issue bonds and borrowing instruments up to a specified cap, which can change! At the time of creating this law, the legislators probably did not imagine that it would be used as a weapon to exact concessions between the parties in power, but here we are. In the last two decades the Federal budget has run perpetual deficit spending budgets due to a mismatch of spending priorities and tax collections. An unwillingness by both parties to match the two sides of this equation is to blame. Typically, the party in power is willing to run deficits while the other party seeks to reign in or massage spending towards their priorities. The stereotypes of fiscal conservatism from Republicans and high spending Democrats are not so cut and dried as it was in past political eras.

We last had a serious risk of breaching the debt ceiling and going into default back in 2011 when Congressional Republicans refused to raise the debt ceiling from its then limit of $14.294 trillion dollars. They sought specific concessions from Democrats in relation to spending, aiming to raise the debt ceiling on a dollar-for-dollar basis tied to budget cuts. A long story short, the United States came perilously close to a full default and legislation was passed in time… but not before rattling international markets and confidence in the United States’ creditworthiness. We saw our credit rating get downgraded for the first time in its history to AA+ from the pristine AAA rating by Moody’s Analytics. Both parties saw pretty drastic falls in their popularity ratings.

This go round, Congressional Republicans are once again in the driver’s seat in their chamber and seek drastic spending cuts over the next decade before being willing to pass legislation for raising the debt ceiling again (it has been raised several times without standoff since the 2011 crisis). The initial bill passed by the House of Representatives seeks to reduce spending by $4.8 Trillion over 10 years with 2/3rds of that coming from discretionary programs (including undoing the IRS funding). In return Republicans are willing to raise the ceiling by $1.5 trillion which should last until the end of March 2024. This is a starting negotiating position and unlikely to be close to the final agreement. As it stands now, the debt ceiling is currently at a Congressionally authorized $31.4 trillion.

 

Kevin McCarthy’s Difficult Task and An Empowered House Freedom Caucus

Back in January, Congressman Kevin McCarthy believed his time had finally come. It was his turn to rise to the Speaker of the House position now that Republicans had finally won back the chamber. Only problem, the Republicans have a razor thin majority at 222 members versus 213 Democrats. After a protracted 15 ballot session, McCarthy won the speakership by agreeing to 4 key items requested by the now empowered and ultra-conservative Congressional Freedom Caucus:

  1. Freedom Caucus members are appointed to the influential Committee on Rules, which has the power to re-write bills before they are submitted for final voting approval.
  2. Made it easier to fire him from the speakership. Now only 1 vote is needed to start the process for removal as compared to a majority of the chamber in all past congresses. Once proceedings start, then they will need a final majority to unseat him. Just a very laborious and obstructive process.
  3. Any single member of Congress can raise “a point of order” to block spending bills. Again, a majority vote would be needed to confirm/reverse this member’s decision. An obstructive action.
  4. Agreed to allow a vote on Congressional term limits. Would be 3 terms (6 years) for congressmen and 2 terms (12 years) for senators. This has not happened yet but is a direct shot at McCarthy who has already spent 16 years as a congressman.

With the above in mind, you may be guessing that the House Freedom Caucus wields immense power and is largely the impetus behind this current debt crisis standoff. McCarthy will need to hold a hard line in negotiations with Biden or else he may see failed legislation in raising the debt ceiling… or worse (for him), the Congressional Freedom Caucus pushing him out of the Speakership.

 

Negotiations With Biden to Raise the Debt Ceiling and Potential Outcomes

On April 26th McCarthy got the “Limit, Save, Grow Act” passed through the House of Representatives on a paper thin 217 to 215 vote. This act is not law, as any piece of legislation would also need to be passed by The Senate and then signed into law by Biden. More than anything else it’s a license for McCarthy to go into negotiations showing that he has enough votes to raise the debt ceiling with specific conditions related to eliminating spending (among other things). Biden has long been calling for a “clean” raise to the debt ceiling, but at this point it’s obvious he will not get his wish.

Over the last two weeks Democrats and Republicans have been negotiating behind closed doors, laying out what they will move on, and won’t acquiesce to giving up. We don’t yet know exactly what the result will be, but it’s expected that the United States could go into technical default as early as June 1st. As of today (May 17th), both Biden and McCarthy have voiced that they do not intend to default.

  • Speaker McCarthy on CNBC’s Squawk Box Program: “I think at the end of the day we do not have a debt default.”
  • President Biden from the White House: “We’re going to come together because there is no alternative. Every leader in the room understands the consequences of failure.”

There is still a belief that both sides are quite far apart in their negotiations as they inch forward day by day. A failure to raise the debt ceiling would see the United States stop paying interest on its outstanding bonds, Social Security checks would stop going out, government programs/agencies would shut down temporarily, and the economy would experience some serious pain as collateral damage. It’s heartening that Joe Biden and Kevin McCarthy seem to understand this, but we are cautiously awaiting a resolution. As the days tick by, there is likely to be substantial volatility in markets as any perceived good or bad news comes out of the negotiations to raise the ceiling.

A timely resolution would probably result in a calming effect on the markets, which could potentially result in a rally. On the flip side, talks dragging out could result in a crisis of confidence and the market going down. History is no indicator of the future, but sometimes history does rhyme a little bit. Looking at a summary of the 2011-year returns of the S&P 500, it was up as much as 8%, down as much as 12%, and ended up finishing nearly flat. For all the chaos that reigned, such a January to December market return of nearly 0% shows how quickly the world moves on from a crisis.