Defanging Debt-Ceiling Doom

We expect similar headlines to these from 2013. Photo by Bloomberg/Getty Images.

Editors' Note: Our discussion of politics is focused purely on potential market impact and is designed to be nonpartisan. Stocks don't favor any party, and partisan ideology invites bias-dangerous in investing. And, since the debt ceiling is mostly a political machination-as we'll explain-we believe this disclaimer is appropriate.

Halloween is around the corner and ghost stories abound. The debt ceiling-the financial version of a horror movie villain that won't die-is back, and like 2011 and 2013 (and dozens of other times before), its approach spooks folks. Last week, Treasury Secretary Jack Lew warned Congress not to dilly dally on raising it or an "accidental" "default on our obligations" could happen. Media is atwitter regarding the possibilities. Adding to concerns, the Treasury canceled a sale of two-year debt due to the uncertainty. But in our view, this movie likely plays out as it has in the past: lots of political bluster and posturing, fearful (false) claims a default looms, and then a last minute debt ceiling increase. Investors should see through this by now: Regardless of politicians' claims, the US isn't in danger of defaulting. The debt ceiling itself is a largely feckless political tool.

The debt ceiling's historical origins are actually rather benign. Prior to its 1917 birth, Congress was required to pass legislation authorizing any bond issue. After the US entry into World War I, this was thought too clunky, and the debt ceiling was the ... ummm ... solution. Note: The debt ceiling is not now, and never has been, related to spending. Congress authorizes spending through budgets or (more often recently) continuing resolutions. Debt is issued to fund those expenditures until it hits the debt ceiling-after that, the Treasury can't issue any new debt. Spending can, in theory, continue.

In recent decades, however, Congress (no matter which party controls it) has wielded the debt ceiling as a bargaining chip, usually accompanied by inflammatory rhetoric.^[i] 2011 and 2013 featured big debt ceiling debates, and despite the noise-including a S&P credit rating downgrade in 2011 and a government shutdown in 2013-no major crisis materialized. Since it couldn't issue new debt after reaching the debt ceiling, the Treasury resorted to "extraordinary measures" to make payments to bondholders, contractors, employees, vendors and citizens. It is doing so now, too, and has been since March. When the government talked these up in 2011, the notion of extraordinary measures stoked fear. However, operating on them for a spell proved the fear false, and the regularity with which we've done so lately makes you wonder just how "extraordinary" these measures really are. Now, allegedly, those measures are set to expire come November. After that, the Treasury must operate with "cash on hand."^[ii] This stirs up the primary fear associated with the debt ceiling: a potential US default.

Despite the hype, a US default is extraordinarily (and we mean it) unlikely. Default is a very specific thing: The US government missing or delaying an interest or principal payment to bondholders. Default is not shuffling around other "obligations" or even delaying entitlement payments, workers' paychecks or vendors' bills. If that were the case, a government shutdown like 1995/1996 or 2013 would probably also constitute default since certain "non-essential" workers^[iii] weren't paid. Plus, legally, not all the Treasury's payments carry the same weight. According to the 14^th Amendment of the Constitution's Public Debt Clause, the US's full faith and credit "shall not be questioned." Supreme Court rulings later interpreted this to mean debt payments take precedent over all other obligations of the government, pure and simple. During the 1985^[iv] debt ceiling fight, the Government Accountability Office agreed with the Supreme Court's interpretation that the Treasury had to prioritize debt payments.

Now, practically speaking, the Treasury can meet those interest and principal payments without issue. The debt ceiling doesn't prevent refinancing maturing bonds, so the question is exclusively: Can the government cover interest payments with tax revenue? The answer is yes: As MarketWatch's Caroline Baum notes, "Last month, for example, the Treasury took in $365 billion in tax receipts and made $21 billion in interest payments. For fiscal 2015, which ended Sept. 30, those figures are $3.2 trillion in tax receipts versus $402 billion in net interest." Tax receipts dwarf debt interest-on an annual basis, they cover them tenfold.

As for concerns the government may not be able to reorder its obligations, the Treasury itself admitted it can prioritize its payments, too. In 2014, a senior Treasury official confirmed under oath that the New York Federal Reserve, which pays bondholders their interest, is "technically capable" of prioritizing those payments, although it isn't easy, we are told.^[v] In a blog post last week, the Treasury confirmed this: "Attempting to manually prioritize among more than 80 million payments made by the federal government each month - to troops, veterans, Social Security recipients, Medicare recipients, vendors, etc. - would be uncharted territory that's fraught with risk."^[vi] The Treasury claims that while they can prioritize, they've never done it before and it might cause financial markets to wobble. Hey, maybe. But that is a short-term market forecast-always subject to error-and it is from the government, which hasn't demonstrated any acumen in foreseeing market moves. It is equally as likely the Treasury being forced to prioritize would invalidate once and for all the fear the debt ceiling would trigger default. And that, folks, is why politicians are highly likely to raise it, whether that is the departing John Boehner cleaning up the barn or his successor.

You see, the debt ceiling is one of Congress' preferred politicking tools, and defanging default fears would render it null and void. The debt ceiling promotes Congressional bickering and blathering, allowing pols to present themselves as champions for fiscal and/or governing responsibility. In other words, it is typical Beltway business as usual. While frustrating for folks who want to see their politicians "get things done," the actual market impact isn't significant.

Plus, you can see the bluster in action now! The Treasury recently canceled a two-year debt sale, which allegedly happened due to "debt ceiling constraints." This is likely a political ploy to grab some headlines and push Congress toward raising the debt ceiling. If a canceled sale-or any of this chatter-signaled real trouble, markets would likely be reflecting this by now. Yet the yields of two-year-and really, all US debt-have barely budged this month. Besides, it is standard operating procedure for the Treasury to make dire proclamations like this during debt-ceiling fights. Treasury Secretary Jack Lew has constantly warned Congress (via letter!) about the repercussions of inaction on the debt ceiling. So did his predecessor. And Treasury secretaries before him! Yet those dire scenarios never manifested. In our view, this is just the revival of another ghost story investors have chewed over for years, not an unforeseen potential negative to worry about.