May 2023 - The Debt Limit Debate

Dear Investors and Friends,

We are receiving many questions about the debt limit debate. The purpose of this letter is to provide our readers with the questions we are receiving regarding the debate and our answers.

What is the Debt Limit Debate?

The debt limit debate refers to the ongoing political and economic discussion in the United States over the statutory limit on the amount of debt that the federal government can incur. The debt limit is set by Congress and is a cap on the amount of money that the government can borrow to fund its operations and pay its bills. On January 19, 2023, the U.S. hit the $31.4 trillion limit.

Have We Been Here Before?

According to the U.S. Treasury, “since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit – 49 times under republican presidents and 29 times under democratic presidents.”

Why Has the Debt Limit Not Been Raised This Time?

The debt limit is a complex and politically charged issue. Republicans are unwilling to increase the debt limit without Democrats agreeing to cut government spending and Democrats refuse to negotiate spending cuts until Republicans agree to pass a debt limit increase without conditions.

What Has Happened Now That the United States Has Hit Its Debt Limit (“Extraordinary Measures”)?

Despite reaching the limit in January, the U.S. Treasury has been able to take certain actions to fund its operations and avoid defaulting on any of its obligations. Collectively these actions are referred to as “Extraordinary Measures”. These actions include but are not limited to 1) suspending investments in certain government funds, 2) deferring payments to certain government programs, and 3) accelerating the collection of certain taxes to increase government revenue.

How Long Will Extraordinary Measures Allow the United States to Meet Its Obligations (“X-Date”)?

The Congressional Budget Office estimates that the government’s ability to meet all its obligations using extraordinary measures will be depleted sometime between June and September 2023. The projected exhaustion date is uncertain because the timing and amount of income tax receipts and government expenses will differ from CBO estimates. The "X-date," also known as the "extraordinary measures exhaustion date," is the date when the U.S. Treasury is projected to exhaust its ability to use extraordinary measures. Once the X-date is reached, the Treasury will no longer have sufficient cash to pay all the government's bills on time and in full.

What Happens If and When the X-Date is Reached?

Most writers state that upon the X-date the US will default upon its debt obligations. That may or may not be true. When the X-date is reached the Treasury would only have the cash on hand to pay a portion of the government's bills as they come due meaning the Treasury would be forced to prioritize payments and certain bills would be paid in full and on time while others would be delayed or only partially paid.

What Would Be the Consequences of An Actual Debt Payment Default?

If the U.S. Treasury does not pay its debt, it would constitute a default on the government's obligations, and create irreparable and significant damage to our country and its citizens. US Treasury bonds have been considered the safest securities in the world, from a default perspective, and a failure to pay our obligations in full or on time would trigger a sharp decline in confidence in our leaders, governmental processes, economy, and financial system, and would lead to a sell-off in all financial markets. Borrowing costs would rise for the government, businesses, and consumers not to mention make it more difficult for many to obtain credit. Given that US debt serves as a benchmark for debt worldwide, the consequences of a US default would reverberate globally, and foreign countries would question the wisdom of holding assets denominated in US Dollars. While we do not want to be alarmist and want to highlight the very low probability of a debt payment default occurring, we do believe that the consequences of failure would be a financial disaster.

What Do Markets Say About the US Probability of a Default?

The credit default swap market allows market participants to hedge against the risk of default. The cost to hedge against a United States default for 6 months has increased 17-fold since the beginning of the year from 15 bps to 260 bps. This implies a probability of default over the next 6 months of 4.15% (assuming a market standard recovery of 40%).

Is RCM Hedging Against a US Default?

No.  Why?  Four reasons.

• This is a very low probability event. In our opinion, lower than the market is pricing in.
• We as a nation are 100% in control of our destiny,
• A recession would act as a pressure release valve. As we discuss in more detail below, political stalemate will likely lead to a severe economic downturn before it leads to a default, and we believe, if it were to get to that point, that a recession would lead our lawmakers to a compromise, and
• While a financial hedge like buying protection in the CDS market, moving our capital to other currencies, or buying gold would protect a portion of our financial savings, the true cost of an actual US debt default would be so vast and devastating that the long term economic and social ramifications would pale in comparison to any savings that could be protected. What we are doing is reaching out to our friends in congress on both sides of the aisle to encourage them to come together in the spirit of unity and compromise sooner rather than later.

What Does RCM Believe Will Happen If and When the X-Date is Reached?

In 2011 when the country faced a similar situation, the Treasury developed a contingency plan in the event Congress acted in a way that jeopardized raising the debt limit. While we don’t know what the Treasury will do this time around, we believe it is fair to assume that its plan would be like the 2011 plan. Under the 2011 plan servicing the debt would take priority over other expenses. Interest would be paid as it comes due and maturing securities would be paid by principal received from new auctions (the auctions would raise the same amount as the maturing principal thereby not raising the amount of debt issued). Timely payments on US debt securities while other obligations are delayed would invite legal challenges and reduced federal spending would put our economy into a recession. Our Treasury would be forced to get even more creative (i.e., minting a collectible platinum coin) and draconian (i.e., government shutdown / not paying entitlement expenditures). If the stalemate were to reach this point, it is our hope and expectation that the economic pain and legal challenges would be severe enough to force our elected representatives into a compromise.

Even if Resolved, Are There “Costs” to Political Stalemates Over the Debt Limit?

Yes, there are many. What follows is but one example. Citing political brinksmanship over raising the debt limit, Standard & Poor's (S&P), one of the major credit rating agencies, cut the rating on the United States in 2011 from AAA, the highest possible rating, to AA+, which was the first time the United States had lost its AAA rating since it was first awarded by Moody's in 1917. The agency stated that it had "lost confidence" in the ability of the U.S. government to manage its finances and address its long-term debt and deficit issues in a timely and effective manner. The apparent well-deserved and prescient action by S&P not only damaged our country's reputation as a global financial leader but also increased our borrowing costs. The Government Accounting Office estimated that the delays in raising the debt limit cost us about $1.3 billion just that year.

Final Thought

We are getting to the point in this debate where even the costs of a “near-miss” will be significant. We urge all members of congress, and the citizenry that influences them, to listen to their “better angels” to find a way to bridge their differences and work together for the common good of the country.

Please reach out to us with questions and comments. Thank you for trusting RCM with your capital. It is a privilege for us to serve you.

Dave and Mike