What is the US debt ceiling and how will the Congress battle over it affect investors?

United States Treasury Secretary Janet Yellen has declared that the US has hit its federal debt limit, kicking off an intense political battle that puts the global financial system at risk.

Congress and the White House have until at least early June to resolve the issue.

The very phrase “debt ceiling” sounds austere and restrictive, as if it’s a lid on government spending. In fact, this cap on United States government borrowing affects only the ability to pay existing bills, not to approve more spending.

But it has become an explosive political issue with the potential to roil financial markets, since a failure to raise the ceiling could eventually result in a first-ever default on some of the government’s obligations.

Here is what you need to know about the situation.

Why is there a debt ceiling?

Its creation, in 1917, made it easier to finance World War I by grouping bonds into different categories, easing the burden on Congress to approve each bond separately.

With World War II looming in 1939, Congress created the first aggregate debt limit and gave the Treasury Department wide latitude on what bonds to issue.

Raising the ceiling lets the government borrow to cover the gap between spending and taxes already approved by Congress.

When did it become a political issue?

The limit was routinely raised without incident until 1953. That year, approval was held up in the Senate in an attempt to restrain president Dwight Eisenhower, who had requested an increase to enable the construction of the national highway system.

The limit has since been raised dozens of times, usually without a fight; both parties agreed to hikes under Republican president Donald Trump without a fuss, for instance.

But the past quarter century has seen the debt ceiling increasingly become a partisan weapon.

What were the biggest fights?

Raising the debt ceiling was among the disputes that caused two shutdowns of the federal government in late 1995 and early 1996.

Another fight occurred in 2011, rattling financial markets and prompting Standard & Poor’s (S&P) to issue the first-ever downgrade of the US government’s credit rating.

Consumer confidence plummeted as did poll ratings for Republicans in Congress and then-president Barack Obama, who agreed to more than US$2 trillion in spending cuts over a decade to end the crisis.

A second debt-ceiling face-off between Obama and Republicans occurred in 2013 as part of a doomed GOP effort to undo the Affordable Care Act. It resulted in the cap being suspended for the first time.

What is the issue now?

The US is bumping up against the current federal debt limit of nearly US$31.4 trillion. Treasury Secretary Janet Yellen says that special accounting manoeuvers should avert a crisis until early June.

These so-called extraordinary measures include withholding regularly scheduled contributions to a federal employee retirement fund and using that money to keep paying debts.

Once those measures are exhausted, the options get more dire, potentially leading to a partial government shutdown and delays in government payments like Social Security checks.

Defaulting on debt would “needlessly plunge the country into economic chaos, collapse and catastrophe while giving our competitors like China a historic boost” said a spokesman for President Joe Biden.

What would be so bad about a default?

Failure to pay holders of US government bonds would make them less desirable as investments, forcing the government to pay more in interest to sell them. That would have cascading effects.

“Financial markets would lose faith in the United States, the dollar would weaken and stocks would fall,” the Council of Economic Advisers, part of the White House, wrote during a debt ceiling debate in 2021.

“The US credit rating would almost certainly be downgraded, and interest rates would broadly rise for many consumer loans, making products like auto loans and mortgages more expensive for families who are subject to interest rate changes or taking out new loans.”

What does the situation mean for stocks?

Most analysts believe the US will avoid a default, so the effects of a political showdown on stock values would be temporary.

“The political squabbles in the coming weeks will likely lead to stock market volatility,” said Shane Sideris, co-founder of Synchronous Wealth Advisors in California.

“But, for long-term investors, there is nothing to worry about. The debt ceiling has been raised 45 times in the last 40 years.”

Still, the volatility could be a problem. The current political situation most closely resembles 2011, when president Barack Obama faced off with a Republican House and ended up striking a last-minute deal capping federal spending.

The S&P 500 Index fell 17 per cent near the end of the debt stand-off and ensuing sovereign credit rating downgrade, and the market did not recover the losses for almost six months.

If the current fight is not resolved before the US misses payments on its obligations the market declines could be severe.

What does the debt ceiling fight mean for the real economy? Could it increase the risk of recession?

If the debt ceiling is not raised, the US would be forced to drastically cut government spending.

That sudden drop would hit as much as 4 per cent of the annualised total for gross domestic product, according to an estimate by David Wilcox, director of US economic research at Bloomberg Economics.

Even a last-minute solution could boost recession risks. Consumer confidence slumped during the 2011 episode.

What does the debt ceiling fight mean for investors in Treasury securities?

Typically, when things darken in the economy, investors buy Treasuries because they are considered risk-free.

That was true in 2011, when Treasuries rose in the weeks after S&P’s downgrade, despite the agency effectively saying that the US government was less reliable in making good on its debts.

Still, there is no guarantee that Treasuries would rally this time, especially with inflation running hot and the Federal Reserve raising interest rates, according to John Velis, a macro strategist at BNY Mellon.

“I'm not comfortable saying because what happened in 2011, we're going to see a repeat of that this time,” he said.

In the worst-case scenario, if the US government failed to make an interest or principal payment, Treasuries would almost certainly trade for less than their face value and investors would lose large amounts of money.

How will it affect mortgages, auto loans and other borrowing costs in the US?

The financial turmoil would likely bleed into the wider credit markets, affecting practically all borrowers.

“If the US government defaults, the credit rating would decrease, not unlike an individual’s credit score, and investors would require higher interest rates to compensate for additional risk,” said Marguerita Cheng, founder of Blue Ocean Global Wealth.

“Higher interest rates mean higher borrowing costs for cars, autos and even student loans. The combination of higher borrowing costs with higher inflation can put more strain on households and businesses.”

Corporate and municipal bonds would also “tank much harder” than Treasury securities, which would still be “the least-dirty shirt in the laundry basket”, said William Bernstein, co-founder of Efficient Frontier Advisors.

How will it affect the value of the US dollar?

Just as with Treasuries, the US dollar typically strengthens when bad things happen.

Even if Treasuries tumbled this time, the higher interest rates that would produce could support the currency in the wake of a credit downgrade, said Philip Mock, founder of 1522 Financial in Tulsa, Oklahoma

The dollar may very well strengthen in the wake of the stand-off and even in the face of a default. Longer term, however, the blow to confidence in the US could undermine the currency’s dominant position in the global financial system.

Who wants to raise the debt ceiling?

Leaders of both major political parties acknowledge that the debt limit must be raised, because the gap between government spending and revenue is so large.

But many Republicans, who took control of the House of Representatives on Jan 3, want to pair a debt limit hike with spending cuts, including potentially to Social Security, Medicare and Medicaid.

“I would like to sit down with all the leaders and especially the president and start having discussions,” said House Speaker Kevin McCarthy, a Republican.

Senator Joe Manchin of West Virginia, a centrist Democrat, says that a possible compromise could involve pairing an increase in the debt ceiling with the creation of special commissions to explore reducing overall US debt and shoring up the Social Security and Medicare trust funds.

But the Biden administration has said that raising the debt ceiling is non-negotiable and should not be conditioned on any other action.

Republicans blame high inflation on spending during Biden’s first two years in office.

Does there have to be a debt ceiling?

Some budget experts and commentators want to abolish the debt ceiling, arguing that the periodic congressional battles over it increase economic uncertainty.

Supporters of the limit say that using it to bargain for spending cuts serves the public interest at a time of historically high debt levels.

The Obama administration considered but rejected untested ways to circumvent the debt limit, including minting platinum coins and placing them in the Federal Reserve or declaring the debt limit a violation of the 14th Amendment prohibition on questioning federal debt.