Mitch on the Markets

June 5th, 2023

U.S. Avoids Debt Limit Catastrophe

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Last week, the White House and Republican leadership in the House announced they had reached a deal on the debt ceiling. Days later, the House passed the measure by a fairly convincing and bipartisan vote tally of 314 – 117, and the Senate passed it the following day with a vote of 63-46. In recent columns covering this issue, I made clear my view that the likelihood of an actual debt default was very low, and also my firm conviction that a deal would ultimately get done. Here we are.

Some members of both parties still oppose the deal, and we’re likely to see more posturing against its passage even after it’s signed into law. I wouldn’t lose sleep over it. Markets are already looking well past the debt ceiling issue, and I think investors should too.1

I’ll review some of the key details of the deal below. But my main focus this week is to imprint on readers how the debt ceiling drama—while causing much distress in the media and worry amongst everyday investors—has consistently proven to be a “looming catastrophe of global proportions” that simply never comes to fruition. In the future, investors might be best suited to ignore these debt ceiling flare-ups altogether.2

Some readers may note that while the U.S. will not miss any obligations or debt payments in this instance, there is still the possibility of a credit downgrade from one of the rating agencies like Fitch, Standard & Poor’s, and/or Moody’s. That’s possible, especially considering Fitch’s recent press release indicating that the U.S. was on watch for a potential downgrade from its sterling AAA credit rating.

The question is whether a credit downgrade matters all that much.

For individuals, when your credit score goes down, it can have meaningful effects on whether you’re extended credit and how much borrowed money costs – think about your mortgage rates, credit card interest rates, auto loan rates, etc.

For developed countries, however, a slight credit downgrade has historically been much less meaningful. The ‘fiscal cliff’ fiasco of 2011 offers a recent example. A major headline in that period was Standard & Poor’s downgrading the U.S.’s debt rating from AAA to AA+, which felt like a huge deal at the time. One would think that a debt downgrade would put upward pressure on the cost of borrowing, which in the case of the U.S., would mean higher yields on U.S. Treasuries.

But as the chart below shows, the opposite happened.

Yield on 10-Year U.S. Treasury Bond (2011)

Source: Federal Reserve Bank of St. Louis3

When Standard & Poor’s downgraded the U.S.’s debt rating, yields on the 10-year U.S. Treasury bonds went down – not up. In other words, the cost of borrowing got cheaper for the U.S. in the wake of the rating agency’s wrist-slap.

The same has been true for other developed countries like Japan and the UK when rating agencies have issued downgrades. Yields did not uniformly go down in every case, but in the instances when yields rose, they did so by fairly marginal amounts. In short, downgrades have not had much impact on developed countries’ ability to borrow.

It’s also worth remembering that rating agencies arguably lack credibility in financial markets. Back in the spring of 2008, Fitch gave Lehman Brothers’ preferred stock an A+ rating just a month after Bear Sterns failed. Lehman would go under just five months later. Fast forward to today, and Fitch says that the U.S. missing a debt payment is a “very low probability event,” while at the same time warning of a possible downgrade. This stuff just isn’t worth investors’ time.

Bottom Line for Investors

The deal on the debt ceiling would suspend the U.S.’s borrowing limit for two years while cutting a few spending programs and increasing military spending by 3%. One concern of markets was that the deal would make significant cuts to government spending, which factors into GDP growth calculations. But those worries have largely been abated, as estimates say the deal would reduce federal spending by about 0.2% of GDP through 2025.

You read that last sentence correctly – all of the drama and hand-wringing over the debt ceiling for a marginal reduction in overall spending, which does not deviate meaningfully from baseline long-term forecasts. As I’ve written before, I don’t think the debt ceiling is worth investors’ time. In a few weeks’ time, no one will be talking about it anyway.

Disclosure

1 Wall Street Journal. May 30, 2023. https://www.wsj.com/articles/biden-and-mccarthys-debt-ceiling-deal-faces-crucial-first-test-in-house-8ae0140e

2 Wall Street Journal. May 30, 2023. https://www.wsj.com/articles/debt-ceiling-deal-does-little-to-change-direction-of-federal-spending-economy-d613388

3 Fred Economic Data. May 30, 2023. https://fred.stlouisfed.org/series/DGS10#

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