By: Dr. Lamar Pierce
Introduction
News about an impending debt ceiling crisis has been everywhere. But now Congress has passed the “Fiscal Responsibility Act,” which raises the federal debt limit. The agreement only holds until 2025, and then we start all over again. Even if this contemporary threat didn’t panic investors this time around, it will return multiple times during any Financial Professional’s career, so it’s important to understand the implications of exceeding the debt limit both for investments and the psychology of those who hold them.
Background
What exactly is the debt ceiling and why do we care? The debt ceiling refers to the maximum amount of debt that the U.S. Federal Government is allowed to take on through the issuance of Treasury securities. Congress sets this limit under its constitutional authority to tax, spend, and borrow money from around the world. So long as total federal debt is below this limit, the Treasury Department can issue bonds that pay for mandatory (e.g., Social Security) and discretionary (e.g., defense) spending as well as interest on existing debt.
If the U.S. government approaches or hits the congressionally-imposed debt limit, however, and the Treasury Department exhausts all extraordinary measures to keep the government funded, a sequence of consequences will ripple across financial markets, the economy, and a broad swath of the population. Extraordinary measures are accounting techniques that allow the U.S. to continue meeting its financial obligations without issuing additional debt and breaching the ceiling. However, these measures only provide temporary relief, and once they're exhausted, the government risks running out of cash to meet its financial obligations, leading to a potential default.
How would a debt ceiling crisis affect money market funds? Even though these funds are thought of as extremely safe, a crisis could significantly impact their risk profile, liquidity, yield, and ability to preserve capital.
A default is a serious event that could have severe consequences for the U.S. economy and financial markets. The U.S. government bond market, considered the safest asset class globally, could be destabilized. This would lead to a sharp increase in interest rates as investors demand higher yields to compensate for the increased risk, thus raising borrowing costs for consumers and businesses and almost certainly leading to an economic recession. Additionally, a debt ceiling crisis can cause dramatic volatility in stock markets as investors reassess the risk profile of their portfolios and react to uncertainty. If the government cannot service its debt, payments for various services, including social security, military salaries, and others, could also be disrupted.
Money Market Implications
One of the great questions we’ve received from Atlas Point customers is how this might affect money market funds that invest in high-quality, short-term debt instruments. These funds are favored by investors for their safety, liquidity, and modest yields. Even though these funds are thought of as extremely safe, a debt ceiling crisis could significantly impact these funds’ risk profile, liquidity, yield, and even ability to preserve capital.
- Risk profile: a debt ceiling crisis would escalate money market risk profiles, primarily through U.S. Treasury bills that are considered the epitome of creditworthiness. The possibility of a U.S.default brought about by a debt ceiling crisis could crush investor confidence.
- Liquidity and yield: money market funds are known for their liquidity, such that they can easily be sold under normal market conditions. If the crisis results in large-scale redemptions, funds could be forced to sell assets quickly, potentially at a loss, to meet these demands. This poses a risk to the funds' net asset value.
- Preservation of capital: a crisis could pose a threat to the primary objective of money market funds--preservation of capital. If fears of a U.S. default become acute, this could lead to a "run on the fund," wherein large-scale redemptions exceed the fund's ability to sell assets quickly enough to raise the necessary cash. In extreme cases, this could potentially result in a breakdown of the fund's ability to maintain a stable net asset value, leading to losses for investors.
Psychological Factors
With all this risk, a debt ceiling crisis can create a high-stress financial environment that could lead to irrational behavior among investors. This irrational behavior can manifest in several ways.
- Panic selling: the fear and uncertainty surrounding a potential government default could drive investors to sell their holdings in money market funds, leading to a "run on the fund." This is even though, historically, all issues surrounding the debt ceiling have eventually been resolved without a full default.
- Herding: investors might follow the actions of others without considering their individual risk tolerance and investment goals, a phenomenon known as herding bias. For instance, if investors see others selling their money market fund holdings, they might do the same, even if holding onto the funds might be in their best interest.
- Neglecting diversification: fearing a default, some investors might withdraw from money market funds and potentially park their capital in assets perceived as safer, thereby disrupting their portfolio balance and diverging from the diversification critical for risk management.