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What is the debt ceiling and why should it be of concern to investors?

May 11, 2023

Redacción Mapfre

Redacción Mapfre

The United States could run out of money to meet its obligations in less than a month. This isn’t due to economic problems: the country is in a solvent position and there aren’t any non-payment precedents on record, but political polarization has caused the negotiation of the debt ceiling, which was previously considered almost merely an administrative process, to lead the country to the precipice of default.

The debt ceiling is the maximum amount that the US Treasury can borrow through the issuing of public debt, which is agreed in Congress. The current ceiling is 31.4 trillion euros.

The United States reached that limit last January, and its government has since reorganized its spending items and accelerated collection of tax receipts, while trying to negotiate with the Republican Senate majority to reach an agreement, a prospect that is far from certain.

The political polarization that the country is experiencing is unprecedented, with a sizeable portion of the population rejecting both the status of certain institutions and election results. This situation makes the agreement difficult, and Treasury Secretary Janet Yellen has already warned in a letter to Republican and Democratic leaders that the country could go into default as early as June 1.

On May 9, President Joe Biden met with the Speaker of the House of Representatives, Republican Kevin McCarthy, although the meeting ended without making any progress on unblocking the debt ceiling.

Biden later emphasized Congress's responsibility to extend the debt limit in statements to the media, saying that it should do so without setting conditions, noting that during Trump’s legislature, the debt ceiling was extended three times “without creating a single crisis.” Both have agreed to meet again this Friday.

Non-payment of debt could have serious economic consequences. By diminishing confidence in the country, public debt yields would increase, as was the case with Spain, Italy, Portugal and Greece during the sovereign debt crisis. Default could also trigger falls in equity markets and a depreciation of the dollar.

"Both parties will reach an agreement at the last minute, as always. It will be some kind of temporary measure that will cause us to have this debate again in a few years' time,” says Jonathan Boyar, principal at Boyar Value Group and adviser to the MAPFRE US Forgotten Value fund, emphasizing that the economic consequences and the fallout for the equity market would be so terrible "that Congress would be forced to approve some measure to allow debt to be paid.”

A cyclical problema

Raising the debt ceiling has always been a recurring problem, although it was previously considered almost merely an administrative process: it has been raised 78 times since 1960, 49 times under a Republican president and 29 with a Democrat in power. The latest blockade echoes what we saw back in 2011, during Barack Obama’s first term, when the Administration drew up a contingency plan that ultimately did not need to be activated.

Gonzalo de Cadenas, director of Macroeconomic and Financial Analysis at MAPFRE Economics, explains that having a debt ceiling is something akin to the “seatbelt paradox”: fastening it gives a false sense of security, which can in turn produce more reckless behavior. That’s why many advocate for its elimination, including Janet Yellen.

Meanwhile, Alberto Matellán, chief economist at MAPFRE Inversión, downplays the debt ceiling and focuses on the need to control the debt spiral. De Cadenas agrees, although he doesn’t believe that the level of debt is excessive in the United States compared to other countries like Japan.

He also recalled that the United States has embarked on an unprecedented industrial policy since World War II, which is impossible to finance without issuing debt. “An industrial policy cannot be understood without the debt element,” says De Cadenas.

 

How does all of this affect me as an investor?

Boyar explains that the debt ceiling is important when investing in US bonds, as it impacts whether the holders of these assets are going to be paid or not. “The solvency of the United States has not been in question for a long time. The fact that some people are even talking about a possible default makes it a big deal,” he argues.

US public debt is a common asset in portfolios, especially those of conservative investors, and the adviser to the MAPFRE US Forgotten Value fund still sees value in US government debt in the short term.

Boyar regards the odds of the US defaulting on its debt as “quite unlikely.” However investors must be prepared for all situations and be able to respond accordingly.

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