Once again, it’s time for CFOs and corporate cash investors to start focusing on another debt ceiling showdown in Congress. In a January 19 letter, Treasury Secretary Janet Yellen declared the United States had reached its statutory debt limit of $31.381 trillion. As Congress failed to authorize more borrowing in time, a “debt issuance suspension period” began immediately, and the Treasury Department started using “extraordinary measures” to keep the government funded through June 5, 2023.

The debt limit debate is nothing new. For the last decade or so, what used to be a routine Congressional procedure turned into a high-stakes, down-to-the-wire political drama that catches the public’s attention. In 2011, the drama resulted in a credit-rating downgrade by Standard & Poor’s to AA+, the first time the U.S. federal government was given a rating below AAA. As in past showdowns, the unimaginable consequence of a default, even a technical one, resulted in the limit being lifted at the last minute but not without lingering concerns. 

Lance Pan

We believe politicians will again come to their senses and authorize spending in time. Or, should they fail to reach an agreement, the Treasury Department may work with the Federal Reserve to prioritize payments on debt obligations to avoid a default. These “extra-extraordinary measures” would most likely be temporary and politically distasteful but might create an additional incentive for Congress to authorize new spending limits. 

CFOs have tools at their disposal to contend with possible consequences of the current debt limit showdown. Reviewing past playbooks and coming up to speed on the details of the situation today, especially looking past headline risk toward the possible timing of the default 'X-date,' can help prepare for this year’s uncertainties. 

The following is a primer with answers to some common questions on the debt ceiling. 

What’s the Debt Limit and Why Does It Exist? 

The debt limit is the maximum amount the U.S. government can borrow to pay its bills. Because the government runs budget deficits, it must borrow money to pay these bills. Congress must authorize borrowing according to the Constitution. 

The debt limit, often referred to as the debt ceiling, was first instituted in 1939 by legislation requiring the Treasury Department to ask for permission to issue debt. A simple majority in the House and Senate is required.

Why Is Raising the Limit So Difficult?

Raising it was a routine procedure in Congress for several decades. As the political environment become more polarized, brinksmanship over the debt ceiling also increased. 

Why Is the Market Particularly Concerned This Time?

Republicans holding a slim majority in the House are refusing to raise the limit without a guarantee from the Biden administration to cut back on spending. The White House refuses to tie raising the limit to spending cuts. This political posturing is not new. 

In past debt-limit showdowns, heated rhetoric of political maneuvering created daily news-cycle headline risk that drove significant fluctuations in market averages. 

What is new, however, is that in winning votes from members of the conservative Freedom Caucus, Speaker Kevin McCarthy conceded to the rule that a single member of Congress could force a new speaker election. He also agreed to their demand of naming deficit spending as a top priority. This means if one member forces a new speaker election, all House business, including the debt limit legislation, must stop until a new speaker is elected. There are signs that Biden and McCarthy are warming up to “honest debates.” 

In past debt-limit showdowns, heated rhetoric of political maneuvering created daily news-cycle headline risk that drove significant fluctuations in market averages. 

What Are the “Extraordinary Measures” and How Long Can They Last?

In her letter to Congress, Secretary Yellen said the Treasury Department will no longer invest funds for certain federal health and retirement plans, including suspending the daily reinvestment of securities held by the Treasury’s Exchange Stabilization Fund and temporarily moving money between government agencies and departments. 

By redirecting investments and payments meant for its internal accounts, these measures create more headroom to satisfy public debt payments without hitting the limit. 

What Is the 'X-Date' and When Will It Be Reached?

Secretary Yellen said that extraordinary measures could be exhausted by June 5. This X-date is the date that the government may literally run out of cash and is unable to issue new debt and pay its bills, including interest to bondholders, payroll checks to government employees and military personnel, and social security checks. Beyond this point, a technical default of the government debt becomes possible. 

You can expect yields to increase on Treasury securities that mature around the X-date as it approaches. 

However, there is considerable uncertainty around the X-date.  CFOs and treasurers responsible for corporate cash investments and liquidity can expect yields to increase on Treasury securities that mature around the X-date as it approaches. Therefore, we advise cash managers to consider selective investment in high-quality securities with longer maturities. Locking in future returns on higher-yielding securities before a flight to quality increases demand and lowers their yield might make sense for many portfolios.

What Happens if the Government Defaults? 

If Congress fails to act, the government may be forced to default on its debt obligations for the first time in history. The event not only would shake investor confidence in U.S. government bonds, raising the prospect of a U.S. recession, global market volatility, and reduced liquidity, but also threaten the reserve currency status of the U.S. dollar, inviting more rating downgrades, and likely raising borrowing costs.

What Can the Treasury Department Do to Avoid Defaulting? 

The transcript of an August 2011 private meeting between Federal Reserve and Treasury officials revealed a plan was formalized to make on-time payments on Treasury debt and delay paying other bills should the debt limit talk fail. This revelation underpins rating agencies’ confidence that the U.S. would not immediately default on its debt, as Moody’s “believes that the Treasury would prioritize interest payments over other expenses to preserve the full faith and credit of the US government and avoid significant disruptions to global financial markets.” By paying bondholders first, the Treasury could theoretically forestall a financial market disaster.

By paying bondholders first, the Treasury could theoretically forestall a financial market disaster.

But as the government runs a budget deficit, those “extra-extraordinary measures” would only be a stop-gap solution. In choosing to pay foreign debtholders over domestic workers,  soldiers, retirees, and healthcare systems, they could prove to be politically disastrous. 

Can the Federal Reserve Do Something?

By law, the Federal Reserve cannot lend directly to a federal department. 

As noted earlier, should the Treasury decide to prioritize payments, the Fed will be tasked to “pend” them in its electronic funds transfer system. The Fed may also purchase Treasury securities that mature around the X-date to take them out of the money market and retirement funds to preserve market liquidity and stability. It could also accept them as collateral for repurchase agreements. In the unlikely event of a default, it could even purchase defaulted securities outright or swap them for non-defaulted ones, albeit at reduced market prices, to keep the market functioning. 

The downside for the Fed to get involved, besides political ramifications, includes the moral hazard of bailing out the government, which makes future fights more frequent and lasting longer. 

Lance Pan, CFA^®, is director of investment research and strategy at Capital Advisors Group.

Note: Any projections, forecasts, or estimates contained in this article are speculative in nature; it can be expected that some or all of the assumptions underlying those forward-looking statements will fail to materialize or will vary significantly from actual results or outcomes.