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The debt ceiling and you: What it means

Debt-ceiling debates are not unusual, so stay disciplined and maintain an investing plan.

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A partial U.S. government shutdown and the looming debt-ceiling deadline have contributed to increased volatility in the financial markets—and to questions and concerns among investors. For perspective on what the debt drama may mean, Viewpoints reached out to Fidelity experts. Here’s a look at the history of the debt ceiling, the risks involved in not raising it, and possible implications for investors like you.

Understanding the debt ceiling

The debt ceiling is a law that sets a cap on the amount the Treasury can borrow. The U.S. first set a general limit on its own borrowing in 1917, as part of the process of funding World War I. The idea was that Congress would set a limit for aggregate U.S. debt rather than get bogged down in approving specific bond issuances.1 Lawmakers intentionally did not link the debt limit to specific debates related to deficits, inflation, or economic growth. Those debates were expected to take place in the normal course of business during the legislative session. For decades, that’s exactly what happened. Raising the debt ceiling was a matter of routine procedure.

However, over the past few decades, the debt-ceiling debate has become more of a way to pressure policymakers to take action on fiscal issues. Given a “firm” deadline, Congress has been using the debt ceiling as leverage to pass policies related to spending, revenues, and other fiscal matters. Also, because the debt has grown fairly rapidly over the past 10 years, Congress has needed to address the debt limit much more frequently.

Congress raised the debt limit to $16.7 trillion earlier this year, and the U.S. Treasury reached that limit in May. Since then, the Treasury has had to resort to a number of special tools to keep the government running. The tools —known as extraordinary measures—consist of certain money the Treasury keeps in reserve to cover the country’s financial obligations. These tools have allowed the Treasury to borrow an extra $250 billion since May. But this money may be exhausted as early as next week.

On October 1, Treasury Secretary Jacob Lew informed Congress that the Treasury will have exhausted its extraordinary measures by October 17. His letter noted that, at that point, the Treasury will have approximately $30 billion on hand to meet U.S. financial commitments, “far short of net expenditures on certain days, which can be as high as $60 billion.”2

The national debt has become a major topic of public discussion since the financial crisis of 2008, largely because the debt is significantly bigger than it has been in the past. Today, U.S. debt represents 73% of gross domestic product (GDP), well above historical averages. The Congressional Budget Office estimates that if we stay on our current path, the debt will be 100% of the economy by 2038. The two political parties have fundamentally different ideas about how to control the debt, leading to the fiscal battles we have seen in recent years.

What happens if Congress doesn’t act?

Should the deadline pass without action from Congress, the federal government may choose to rely on its cash reserves and incoming revenue to pay its bills and make interest payments on outstanding debt.

Karthik Ramanathan, a senior vice president and director of bonds at Fidelity and former U.S. Treasury Department official, notes that some market experts believe the Treasury could continue to pay selected bills on a day-by-day basis using tax revenues. This “prioritization” process would mean that the government would make the payments it deems most necessary, likely including those related to interest and principal on the debt, in order to avoid a default. Ramanathan is skeptical that prioritization is workable. “This would be breaking new ground, and the Treasury has repeatedly stated that it can’t prioritize payments given computer system limitations,” he says.

Barring that type of approach, at some point—likely between October 22 and November 1, according to the Bipartisan Policy Center—the government could write checks that would bounce or miss payments altogether.3 What would happen next involves some conjecture given that the Treasury has never missed an interest or principal payment. The Treasury's view is that the situation would be catastrophic: “Credit markets could freeze, the value of the dollar could plummet, U.S. interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse,” it says.4

Nancy Prior, president of Fidelity’s money market group, notes that a default could mean that one or more of the credit rating agencies might downgrade their long-term rating of the United States. However, she says, “Even if the long-term rating for the United States were downgraded, we do not expect a downgrade of the short-term rating.”

Implications for investors

Amidst the current uncertainty, the value of staying disciplined and maintaining a sound investing plan is critical. Many investors stuck to that approach during the debt-ceiling debates January 2011 and January 2013, under the expectation that last-minute negotiations would result in an agreement. And that strategy paid off, as markets rebounded once a deal was done.

That may help explain the relatively measured reaction of investors to the current stalemate. Frequent 11th-hour deals “seem to have created apathy among investors,” Ramanathan says. Despite the increased volatility lately, Ramanathan points out that stock market volatility, as measured by the VIX, generally rapidly declines following a debt-ceiling increase. He calls this the “storm before the calm.”

Meanwhile, Fidelity has a positive outlook for the U.S. and global economies. According to the October Monthly Business Cycle report, the U.S. and several non-U.S. developed economies are improving cyclically, while the near-term outlook for China and some developing economies has improved. It notes that fiscal and structural challenges pose a risk to that outlook, particularly in the U.S. and Japan.

While the debt-ceiling deadline is dominating headlines, there also are other factors that are likely to affect the markets. “Investors are uncertain about how the Federal Reserve will approach tapering quantitative easing, so we can probably expect higher volatility this fall—but the fiscal debates are likely to be only one of the drivers,” says Dirk Hofschire, Fidelity’s senior vice president for asset allocation research. “And any volatility comes within the benign context of a steady economic backdrop, without a lot of inflation.”

The upshot: While the prospect of default is unsettling, the likelihood is low, and economic fundamentals remain sound—so, as long as you are confident in your investment strategy, today’s debt drama probably does not warrant major changes to your plan.

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Views expressed are as of October 11, 2013, and may change based on market and other conditions. The opinions provided are those of the speakers and not necessarily those of Fidelity Investments. As with all your investments through Fidelity, you must make your own determination as to whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation, and your evaluation of the security. Consult your tax or financial adviser for information concerning your specific situation. Investing involves risk, including the risk of loss.
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4. “The Potential Macroeconomic Effect of Debt Ceiling Brinkmanship,” U.S. Department of the Treasury, October 2013.
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