The US Debt Ceiling Could Flatten Your Portfolio

The US is in crisis, with the country’s debt hovering right at the maximum “debt ceiling” level. And while there’s a decent chance we’ll skim past the absolute worst-case scenario, it’s still a possibility – as are a lot of the still-not-perfect backups. In any case, you’ll want to be prepared for whatever happens. So here’s what the debt ceiling is, why it matters for investors right now, and what each government solution would mean for markets and your portfolio.

What is the debt ceiling?

If you’ve got a credit card, you’re (hopefully) aware that it comes with a spending limit, outlining the maximum amount of money you can borrow. Well, in the United States, the government has something similar called the "debt ceiling" – although it comes with a slightly higher limit of $31,381 trillion, about one and a half times the size of the country’s economy. That limit is set by Congress, which has the power to increase it if required.

The reason why the US government needs to borrow in the first place is that it spends more than it makes in taxes and other revenue. After all, paying for initiatives like social security, Medicaid, the army, education, and transportation doesn’t come cheap. To afford all of that, then, the government issues debt in the form of securities like Treasury notes and bonds. That’s no easy fix, though: the government has to pay a ton of interest just to service its existing debt.

The debt ceiling exists to make the government accountable for its financial decisions and to allow politicians, investors, and onlookers to keep tabs on excessive government spending. For good reason, too: it’s been shown that spending in excess may have nasty side effects, slowing economic growth, raising interest rates, and reducing the government’s ability to respond to economic downturns. Plus, when debt is seen as too high, investors may lose trust in the government's ability to keep up with its interest payments.

What’s the big deal, then?

Shopaholic Uncle Sam already maxed out its credit card allowance in January this year. Since then, the government’s been relying on "extraordinary measures" – otherwise known as accounting tricks – and its cash balance to keep up with the bills. But time's running out: it may exhaust all of its backup moves as early as June, although the exact date would depend on how much tax the government’s received by then.

So unless Congress agrees to raise the debt limit, or at least grant a temporary extension, the government would either face a default on its debt or be forced to implement severe reductions in state spending. At that point, the situation could turn really bad, really quick. A partial government shutdown would lead to disruption and delays, and any suspension of payments like social security, Medicaid, and military salaries would impact millions of Americans.

The economic impact could be staggering. The government may need to slice off payments worth around 10% of the economy, bringing already struggling growth down by the high single digits in the case of a slower, protracted default – and over one percent in the case of a short default. That would almost guarantee a recession. It may also have longer-term effects, like undermining the US dollar’s status as the world’s primary reserve currency and hampering the government’s ability to respond to future economic crises or invest in essential public services and infrastructure.

Real GDP (i.e. after inflation) could suffer a double-digit drop. Source: CEA analysis

But the biggest impact of all could be financial. Any missed debt payments could lead investors to seriously question the government’s creditworthiness – the US lost its triple-A rating in the latest standoff in 2011, if you recall. That doubt would wreak havoc on the all-important funding markets, which finance major institutions, and raise volatility in almost all other markets. And given today’s extremely uncertain macro environment of already elevated interest rates and political tensions, those price moves could be a lot more extreme than investors might expect.

How likely is that outcome?

The risk of a doomsday scenario has never seemed so high, it’s true, but we are likely to swerve that disaster. The stakes are just too high. So instead, it’s more likely that the debt ceiling will eventually be raised and the government will kick the can down the road, just as it’s done many times before.

But it’s all down to timing. See, the reason the debt ceiling hasn’t been raised already is due to politics, in every sense of the word. The House of Representatives – which plays a crucial role in the legislative process – is currently controlled by Republicans. The party can use its sway to delay any deals while asking for major spending cuts that fit with its policy – but with Democrats refusing to even enter the negotiation table so far, we’re looking at a very dangerous game of chicken. So even if the risk of a drawn-out default is low, tensions are likely to ramp up as we approach that fateful date, with each party incentivized to make issues seem worse than they really are to gain a concession from the other side. That makes a short-term “technical” default a whole lot more likely, and significantly raises the risk of higher volatility over the next few weeks.

Now, that’s not the only way this has to go down. Lawmakers could use what’s called a "discharge petition" to try and bypass the Speaker's approval, although the odds of success would be slim. A slightly more likely scenario would see Congress buy more time by passing a bill to temporarily “suspend” the debt ceiling for several weeks or months. A more extreme and riskier option would be for the president to create a coin worth $1 trillion, deposit it with the Federal Reserve, and use that money to pay the government’s bills. So that’s the good news: even if no agreement is reached, there’s no guarantee that the government will default on its debt, even temporarily. But let’s face it, even if we avoid the worst-case scenario, the other options will hardly calm investors’ nerves. Markets, then, will probably stay volatile until a more convincing solution is found.

What can I do to protect my portfolio?

A non-resolution might not look likely, but it’s still a risk worth protecting yourself against. Remember, any potential fallout could be huge, so volatility will likely stay high until the issue’s properly resolved. Some markets are already reflecting heightened risks, actually: investors now require higher yields to justify the risk of holding bonds that expire around the three most likely dates of a potential default, June, July, and October. Plus, the cost of insuring against the US government defaulting on its debt – which works using a derivative contract called a credit default swap (CDS) – has spiked sharply. That being said, most markets appear to be underestimating the potential impact, with stock volatility remaining surprisingly muted so far.

The cost of insuring against a default of the US government has reached a record high. Source: Goldman Sachs

If you have a truly long-term investment horizon and can handle short-term ups and downs, your best option may well be to do nothing – for now, at least. But if you want to reduce the risk of a sharp loss over the short term, you’ve got a few options.

First things first, make sure you’re neither too leveraged nor or too piled into one investment theme. Ideally you’d have no leverage and a well-diversified portfolio made up of different asset classes, sectors, and styles. An absolute no-no is selling naked options, that’s ones without a hedging corresponding position that would minimize losses, as they risk leaving you with huge losses if the unthinkable does happen.

If you want more specific protection against the debt ceiling, you could consider picking up assets that are likely to benefit from the tension. That’s ones like Gold – which should be buoyed up by investors seeking safe-haven assets and rising concerns around the US dollar – and defensive currencies like the Japanese Yen and the Swiss Franc, which should appreciate versus the US dollar.

For those who want a more potent hedge, you could buy stock volatility – like the VIX, an index that tracks stock market volatility – through an exchange-traded fund (ETF) or contract for difference (CFD). That won’t come cheap though, and your costs will keep piling up over time. You could also buy a put option – or a less costly put-spread, where you buy and sell puts based on their distance from their strike prices – on a stock index like the Vanguard Russell 2000 ETF (ticker: VTWO, expense ratio: 0.10%), which is more concentrated toward smaller, riskier firms. You could do the same with high-yield credit ETFs like the iShares iBoxx $ High Yield Corporate Bond ETF (ticker: HYG, expense ratio: 0.48%). But if that’s the road you want to take, make sure you have an exit strategy in place – any profit you make can turn in the other direction very soon once the proverbial stuff hits the fan, and the price of hedging heads to the heavens.

A few interesting buying opportunities could reveal themselves down the line too. When the debt ceiling concerns are properly addressed, longer-maturity bonds could well feel the benefit. Longer-maturity bonds may do well even in the case of a standoff, as investors would likely flock to their relative safety.

What’s most important, though, is not to underestimate the risks around the debt ceiling, no matter which approach you take. You can hope for the best, of course, but it’s always best to prepare for the worst.