Congress voted to increase the debt ceiling giving markets a temporary reprieve until December, when the debt limit will need to be addressed again. The United States has never defaulted on government debt and failing to raise the debt ceiling is unlikely. Still, Democrats and Republicans playing politics with the deadline can have real consequences, as we saw in August 2011 with the downgrading of the United States credit rating.
This week, LPL Research answered some important questions regarding the debt ceiling and what investors should expect in the coming months.
- What is the debt ceiling?
The debt ceiling is the limit on how much the federal government can borrow. Unlike every other democratic country (except Denmark), a limit on borrowing is set by statute in the U.S., which means Congress must raise the debt ceiling for additional borrowing to take place.
Why is it important to raise the debt ceiling?
The government uses a combination of revenue, mostly through taxes, and additional borrowing to pay its current bills—including Social Security, Medicare, and military salaries—as well as the interest and principal on outstanding debt. If the debt ceiling isn’t raised, the government will not be able to meet all its current obligations and could default.
Has Congress always raised the debt ceiling?
Yes, whenever needed. According to the Department of the Treasury ("Treasury"), since 1960 Congress has raised the debt ceiling in some form 79 times, 49 times under Republican presidents and 30 times under Democratic presidents. As shown in Figure 1, Congress has regularly raised the debt ceiling as needed. In fact, every president since Herbert Hoover has seen the debt ceiling raised during their administration.
How would a technical default impact the financial markets?
In 2011, which is probably the closest comparison to this year, the S&P 500 Index fell by over 16% in the span of 21 days due to the debt-ceiling debate and subsequent rating downgrade. The equity market ended the year roughly flat, so investors who were able to invest after that large drawdown were rewarded. However, that large drawdown was due solely to the policy mistake of not raising the debt ceiling in a timely manner. It’s likely that if Congress were to wait until the last minute again before raising or suspending the debt ceiling, equity markets would react similarly.
Despite the downgrade, demand for intermediate and longer-term Treasuries actually picked up during the market volatility, pushing yields lower, as Treasuries are generally considered a "safe haven" asset. While that may have been the market reaction in 2011, there is no guarantee that, in the event of a technical default and further rating downgrades, Treasury securities would have a positive return this time around—particularly if Treasury securities lose their reputation as bonds that have no default risk.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.
This research material has been prepared by LPL Financial LLC.
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