All eyes remain on the US debt ceiling gridlock. Markets have largely shrugged off the possibility of the US defaulting on its debt, and Washington has finally made significant progress on its debt ceiling bill with an in-principle agreement between President Biden and House Speaker Kevin McCarthy to raise the debt ceiling. Nonetheless, it remains alarming that Congress has mere days left to approve a deal to avert a US default (projected to take place by 5 June), that could have calamitous effects on the global economy.

For easy reference, here is a list of questions and answers regarding the US debt ceiling issue, along with some recent developments.

1. Why has the debt ceiling been in focus of late?
   The debt ceiling was created by Congress in 1917, to set a maximum of outstanding debt the US government can incur.
   
   
2. What is the debt ceiling?
   The debt ceiling was reached in January 2023 when the total national debt hit USD31.4t. In response, the Treasury invoked “extraordinary measures” to continue operating. In May 2023, Treasury Secretary Janet Yellen warned that these measures could be exhausted by early June 2023 (the x-date). Given our proximity to the x-date, Congress must now vote to suspend or raise the debt ceiling or risk a US default.
   
   
3. What is the “x-date”?
   The x-date refers to the point where the US government’s funds are no longer sufficient to meet its financial obligations. Most current estimates are for early June, but it is not possible to gauge the exact date.
   
   
4. What happens if an agreement is not reached by the x-date? / What are the consequences of a US default?
   
   1. Higher borrowing costs: US Treasuries have long been viewed as risk-free assets, keeping their rates very low. A default would cause borrowing costs – including credit card, car loans and mortgage rates – to spike because US debt serves as a critical benchmark for various forms of credit.
      
      
   2. Risk-asset price fragility: Higher risk-free rates will inflate discount rates, which are used to value assets. Steeper discount rates will compress valuation across asset classes, hitting investor confidence.
      
      
   3. Delayed payments: Payment to millions of civil servants, social security beneficiaries etc. will be delayed indefinitely. Businesses and households will be unable to pay their bills while awaiting government receivables. This may lead to further tightening of liquidity and cause the economy to accelerate towards a recession.
      
      
   4. Broad financial instability: The belief that America’s government will pay its creditors on time underpins the smooth functioning of the global financial system. It makes the dollar the world’s reserve currency and US Treasury securities the bedrock of bond markets worldwide. A breach of the US debt ceiling would likely cause severe damage to global economies.
      
      
5. What is the most likely outcome of the existing debt ceiling gridlock?
   
   • No disorderly default – Noting the above repercussions (see point 4), we believe that it is not in the interest of either side of congress to allow a disorderly default. There is a high likelihood that Congress will approve a raised debt ceiling (see point 6), even if it just barely before the x-date.
     
     
   • Greater fiscal prudence to alleviate the need for further monetary tightening – Greater fiscal prudence of the US in managing its ballooning debt would (a) ease inflationary pressure, and (b) tighten consumer confidence in the medium term. This implies that the Fed need not hike much further as credit conditions would already tighten in response to such spending cuts.
     
     
6. How often has the debt ceiling been raised?
   Since the debt ceiling was enacted in 1917, subsequent “crises” of a debt ceiling imbroglio have come and gone. Congress has always acted when called upon to raise the debt ceiling. Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt ceiling – 49 times under Republican presidents and 29 times under Democratic presidents.
   
   
7. Why does the debt ceiling need to be raised so often?
   When the US government spends more money than it receives in taxes and other revenues, it incurs a deficit. Since 2001, the federal government’s budget has run a deficit each year. To illustrate, starting in 2016, increases in spending on Social Security, health care, and interest on federal debt have outpaced the growth of federal revenue. During the pandemic, spending further increased by about 50%. This persistent deficit has been financed by the US government incurring an ever-increasing amount of debt.
   
   
8. Why the current delay in raising the debt ceiling?
   Revisions to the debt ceiling requires approval and agreement of both chambers of the Congress. Although the debt ceiling has at times been raised or suspended without much fanfare, it becomes trickier under a divided Congress; In this instance, the House Republicans are leveraging on the impasse to extract major spending cuts from the Democrats in the name of fiscal prudence.
   
   In 2011, the US got so close to default that its credit rating was downgraded by credit rating agency S&P, citing risk of default caused by “political brinkmanship”.
   
   
9. Are US Treasury Bonds still a safe haven?
   US Treasuries are widely considered amongst the safest assets in the world, against which pricing of most other financial assets is benchmarked. US Treasuries are considered safe because their interest and principal payments are backed by the faith and credit of the US government. So long as the US continues to hold the world’s reserve currency (i.e., USD), they would always be able to print the difference should there be a shortfall of lenders to finance these payments when they come due. Furthermore, as outlined above, the probability of a US default remains remote.
   
   US Treasuries are so entrenched as a safe haven asset that in 2011, when credit rating agency S&P downgraded the US citing risk of default caused by “political brinkmanship”, US treasury bonds ironically rallied in its aftermath as investors flocked to “safety” as a Pavlovian response.
   
   Nonetheless, as this debt ceiling issue highlights the US’ burgeoning debt and persistent deficits, investors would do well to diversify with exposure to low risk, investment grade credit issuers to complement their holdings in “risk-free” government debt as part of an overall fixed income portfolio.
   
   
10. How should we position our portfolios in view of the current debt ceiling gridlock?
    
    The debate around the debt ceiling is likely to result in much market volatility over the next few months. Given this volatility, we believe investors would be better off staying with quality assets:
    
    1. Staying with high quality equities (consistent cash flow, strong balance sheets) and fixed income (A/BBB rated), given that these companies/issuers are better positioned to weather a slowdown,
       
       
    2. Holding gold as a risk diversifier, noting that it stands to gain either way under opposing outcomes of recession and inflation, and
       
       
    3. Remaining with short duration (3-5Y) credit noting that persistent US debt sustainability concerns would not bode well for long-term obligations.
       
       
    
    
    
11. These points have been addressed in our past CIO publications regarding the debt ceiling:
    
    • US Debt Default Risks and its Implications (27 April 2023)
    • Credit: US Debt Ceiling and Credit Implications (20 January 2023)