Debt Ceiling 101 

The current debt ceiling is set at $31.4 trillion. There has been a marked run-up in debt this century: Since 2001, the U.S. has spent nearly $1 trillion more than it receives in taxes and revenue. While brinkmanship on both sides of the aisle around raises is nothing new, this issue has become a renewed source of political gridlock in recent years, primarily as Republicans have tried to use the debt ceiling as a bargaining chip to extract spending concessions from Democrats. When the debt ceiling is reached, the government is essentially out of money and may be unable to pay its bills, which could lead to it being forced to make cuts to essential programs, such as Social Security and Medicare, until the debt ceiling is raised.

Current Posturing

President Biden and House Speaker McCarthy have been engaged in ongoing negotiations regarding the debt ceiling, but a resolution has not yet been found. Major sticking points of the negotiations include unspent Covid-19 relief funds, student loan forgiveness, federal budget caps, reforming energy permitting, and work requirements for some recipients of federal aid. With the default date looming and negotiations ongoing, the market has begun to price in the possibility of a default, with treasury yields and credit default swaps rising in price.

Consequences of Default

A default on national debt would have an extreme impact on the global economy and U.S. credit worthiness. A default could cause a devaluation of the U.S. dollar, and a loss in investor confidence in the government’s ability to repay its debts could cause a sell-off of U.S. assets, including Treasury bonds. An increase in interest rates would further stall the U.S. economy, as business would face an even more expensive cost of debt.

On Wednesday, ratings agency Fitch put the United States’ credit on negative watch as a precursor to a possible downgrade. The Standard and Poor’s (S&P) rating had been previously downgraded during the 2011 debt ceiling debacle. If Fitch does ultimately downgrade, that would leave the United States with only one major rating agency giving the debt the highest AAA rating. Unfortunately, the fact that S&P had previously downgraded U.S. debt without any lasting consequences has emboldened some lawmakers into believing that they could successfully default for a short period of time without dire outcomes.

Meanwhile, the mere possibility of default is pushing up Treasury yields. As Treasury yields are the principal index for almost every sector of fixed rate borrowing, the consequences have become immediately apparent in financing activities. U.S. 10-year yields are up nearly 45 basis points in the last two weeks, and shorter-term yields, like the two-year and five-year, are up more than 55 basis points.

This run-up in yields, which would only be amplified by a true default, should also be putting more pressure on mortgage-backed securities (MBS) and U.S. Treasuries currently held on bank balance sheets. Lower coupon bonds purchased over the past several years will face steeper mark-to-market losses on these securities, a key factor involved in bank collapses this year.

According to whitehouse.gov, “An actual breach of the U.S. debt ceiling would likely cause severe damage to the U.S. economy. Analysis by CEA and outside researchers illustrates that if the U.S. government were to default on its obligations—whether to creditors, contractors, or citizens—the economy would quickly shift into reverse, with the depth of the losses a function of how long the breach lasted. A protracted default would likely lead to severe damage to the economy, with job growth swinging from its current pace of robust gains to losses numbering in the millions.”