How will the Market React if the U.S. Hits its Debt Ceiling?

The U.S. has a debt ceiling, which means it cannot borrow once the ceiling is reached. Today, it’s a staggering $31.4 trillion. In 2011, it was “only” $16.4 trillion. Because the U.S. Treasury borrows to fund everyday expenses, hitting the ceiling means that existing programs cannot be funded. To avoid this from happening, Congress must pass legislation to increase its debt ceiling.

2011 was the last time this was a serious concern. A deal was eventually reached on July 31, just two days before the catastrophe hit. However, the debacle cost the U.S. its pristine investment grade rating, which it had long cherished since 1941, when Standard & Poor’s downgraded the country’s credit worthiness by a notch from AAA to AA-plus.

During that summer, the volatility index spiked and gold prices rallied. Surprisingly, so too did U.S. Treasuries as yields fell from 2.85% to 2.15% in July (prices and yields move in inverse directions).

It appears likely that we are about to relive 2011 very soon.

Earlier this week, I heard some estimating that the debt ceiling would become triggered in September. By mid week, others were saying that June is more likely, citing weaker tax receipts than previously expected as the culprit.

House Speaker Kevin McCarthy delivered a speech to the New York Stock Exchange on Monday with a promise to increase the debt ceiling. However, McCarthy – who won his speakership on the 15th ballot, something unseen since before the Civil War – has an exceptionally weak grip on his fellow caucus members. His assurances don’t carry much sway.

Is catastrophe priced in? No, but for good reason. As Yogi Berra said, “nostalgia ain’t what it used to be.”

Investors have come to expect dysfunction, especially in Washington. We expect the U.S. Congress to eventually reach a deal, but it won’t be until the last minute. They may even miss the deadline by a day or two.

In July 2011, the S&P 500 only sold off by about 2% in the month leading up to the deal. In the week thereafter, the S&P 500 moved up or down by at least 4% in half of the daily trading sessions. But, while the credit downgrade from Standard & Poor’s and political posturing didn’t help, the major cause of the 2011 selloff was the European debt crisis – not the debt ceiling standoff or credit downgrade.

Just 5 months later in February 2012, the S&P 500 traded higher than it did the previous July 2011 before the debt ceiling debacle caused its disturbance.

We won’t be raising cash or selling stocks ahead of the debt ceiling discussions. There will surely be days of volatility where the market is up or down 2% in a single session, but like all macroeconomic events, this too will pass and a resolution will be reached. Instead, we will make use of any volatility to purchase stocks on our watch list to add to client portfolios.