The impending doom of the debt ceiling being reached has been a hot-button topic lately. With an agreement having been reached in principal, it’s likely that this issue, that was never really a realistic issue, is now behind us.

1 – Some basics about the debt ceiling

The debt ceiling is a legislative limit on the amount of debt that the government can issue to fund its operations and meet its financial obligations. When the debt ceiling is reached, the government is not allowed to borrow additional funds unless the limit is raised or suspended by Congress.

Some of the effects of the debt ceiling are quite significant and why we heard about them in the media as consistently as we did.

a) Government Shutdown: If the debt ceiling is not raised and the government is unable to borrow more money, it may be forced to operate with only the available cash on hand. This can lead to a government shutdown, as there may not be enough funds to pay for essential services and government operations.

b) Default Risk: Failure to raise the debt ceiling could result in the government defaulting on its debt obligations, which would have severe consequences for the economy. Defaulting on debt would damage the government’s creditworthiness, increase borrowing costs, and potentially trigger a financial crisis. It would also undermine confidence in the U.S. dollar and have ripple effects on global financial markets.

c) Economic Uncertainty: The uncertainty surrounding the debt ceiling debate can have negative effects on the economy. It can lead to increased market volatility, lower business and consumer confidence, and potentially impact investment and economic growth. The prospect of a government default or shutdown can create uncertainty and hinder long-term planning and economic stability.

d) Credit Downgrade: In the past, failure to raise the debt ceiling has led to credit rating downgrades for the United States. A lower credit rating could increase borrowing costs for the government, businesses, and consumers, as investors demand higher interest rates to compensate for the increased risk associated with U.S. debt. Prior to the ceiling having been increased, Fitch, the rating agency, placed the US’ credit rating of AAA on negative watch. Since then, short-term yields have increased as investors demand a higher yield in exchange for the perception of less security in the US treasury market.

It is worth noting however that the debt ceiling is a self-imposed constraint and does not directly address the underlying issues of government spending and revenue. The political dynamics surrounding the debt ceiling can often be contentious, and its impact on the economy and financial markets highlights the importance of timely and responsible fiscal management. Today, the Republicans accuse the Democrats of not doing enough to address the debt ceiling. In the last regime, the Democrats accused the Republicans of not doing enough to address the countries mounting debt. Unfortunately, it seems that the debt ceiling has become more of a political pawn than an issue that either side genuinely wants to address. But this is not the time nor the place for that discussion. 

2 – How Will the Debt Ceiling Increase Affect the Markets?

Granted, the proposed increase to the debt ceiling still needs to be voted in by both parties in order for the agreement to be ratified by Congress. Having said that, the deal is agreed to in principal with both sides making concessions in order to avoid a potential June 5th default, which would have been disastrous for the US, it’s population and could have sent ripples throughout the entire global financial community.

In most cases, the effects of raising the debt ceiling are typically aimed at preventing the negative consequences of reaching the debt ceiling, which I mentioned in the previous response. When the debt ceiling is raised, the government is able to borrow additional funds to meet its financial obligations and continue operating without interruption. Here are some potential effects of raising the debt ceiling.

a) Maintaining Financial Stability: Raising the debt ceiling helps preserve the financial stability of the government, which in turn can have positive effects on the broader economy. It ensures that the government can meet its debt obligations, thereby preventing a potential default and the associated negative impacts on interest rates, credit markets, and investor confidence.

b) Sustaining Confidence: Raising the debt ceiling can help maintain confidence in the U.S. government’s ability to honor its financial commitments. This confidence is crucial in preserving the credibility of U.S. debt instruments, such as Treasury bonds, which are widely regarded as safe investments. A loss of confidence due to a failure to raise the debt ceiling could result in higher borrowing costs for the government and could negatively affect the broader economy.

c) Mitigating Market Disruptions: Raising the debt ceiling in a timely manner can help avoid disruptions in financial markets. The uncertainty surrounding the debt ceiling debate can lead to increased market volatility and investor anxiety. By raising the debt ceiling and removing or reducing this uncertainty, it can contribute to more stable financial markets.

d) Impact on Interest Rates: The resolution of the debt ceiling issue can influence interest rates, particularly in the short-term debt markets. As mentioned earlier, during periods of uncertainty, interest rates may rise as investors demand higher yields to compensate for increased risk. Once the debt ceiling is raised, it can help alleviate these concerns, leading to a stabilization or decrease in interest rates.

e) Lowered Volatility: The uncertainty surrounding the debt ceiling debate can lead to increased market volatility as investors become concerned about potential disruptions to government operations and the potential for a default. Once the debt ceiling is raised, it helps alleviate this uncertainty, which can lead to a reduction in market volatility. Investors may feel more confident in their investment decisions when the immediate risk of a government funding crisis is diminished. “Expensive” stocks in the technology sector continue to trend upwards in a more forgiving environment. Yields on the 10-year US treasury have also retreated in the past few days given the lowered liklihood of a default and potential downgrade in US credit rating. 

 3 – Clear(er) Sailing on This Front in the Short-term….Uncertainty Beyond

The deal the US has in place to suspend the debt ceiling will move this issue down the road until January 2025, barely 2 months after the November 2024 election. Assuming this deal is ratified, the debt ceiling should not be a major point of contention in financial markets until it is time to address it once again. It will likely only represent a political talking point and present a further ability for political posturing going into election season. Beyond that, the same risks of potential default, higher interest rates will likely rise to the surface.

Until then, I believe we are past this blip of the radar from a performance perspective. Our concern remains a potential June interest rate hike south of the border in a further effort to curb inflation, which remains around at a 5% increase from last year’s 8.6%.

This information has been prepared by James Hogan who is an Investment Advisor/Portfolio Manager for iA Private Wealth Inc. and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor/Portfolio Manager can open accounts only in the provinces in which they are registered.

iA Private Wealth Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. iA Private Wealth is a trademark and business name under which iA Private Wealth Inc. operates.