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Stop us if you’ve heard this one before: US lawmakers are clashing over a legislative action to raise the federal debt ceiling. The issue has been percolating for months but could come to a head this summer as the US Treasury starts running out of money to pay its bills.

The decision to increase the nation’s debt limit is often a routine one — except in years when Congress is divided, like it is now. With Republicans controlling the House of Representatives and Democrats in command of the Senate, the scene is set for what could be one of the most contentious debt ceiling showdowns in recent history.

So far, Democrats have said they won’t negotiate on the issue, while many Republicans have said they won’t vote to lift the debt limit without some additional agreements to curb federal spending.

“This could be the worst standoff we’ve ever witnessed,” says Capital Group political economist Matt Miller. “It certainly has the potential to be at least as bad as 2011.”

That’s the year Standard & Poor’s cut the United States’ prized AAA credit rating to AA-plus (where it remains) amid concerns about the government’s budget deficit, a growing long-term debt burden and political conflicts over raising the debt limit. The move unnerved US financial markets for a time, but they quickly recovered.

In fact, not long after the 2011 credit rating action, US stocks embarked on one of the longest bull markets in history — a virtually uninterrupted run from 2011 until the start of the COVID-19 pandemic.

“I think the lesson from 2011, and a subsequent debt ceiling impasse in 2013, is that these events can disrupt markets for a while — sometimes even weeks or months — but if we look at history, they don’t tend to have a lasting impact on investors,” Miller says. “That’s assuming we get a reasonable resolution.”

On 19 April, House Speaker Kevin McCarthy unveiled legislation that would raise the debt limit by $1.5 trillion. The bill also includes several other provisions to curtail federal spending. It remained unclear whether there were enough votes to pass the bill in its current form.

What happens if the US defaults on its debt?

Of course, the worry is that the US could — in the middle of a particularly nasty debt ceiling impasse — wind up in technical default on its many debt obligations, including payments to bond holders. It’s hard to predict what might happen next, but there are many who say it would roil the financial markets and jeopardise the US dollar’s status as the world’s reserve currency.

The chances of a technical default — which would occur should a bond payment be missed or even delayed — are very low but not zero, according to Tom Hollenberg, a Capital Group fixed income portfolio manager.

“It's important to make a distinction between the situation we are facing in the US and something much worse, like an Argentina-style default, where investors lose their savings. Nobody seriously believes that will happen here,” Hollenberg says. “In the US, the probability of even a technical default, or a delayed payment, is between 5% and 10%, in my view. It’s certainly not my base case, but it’s something I can’t ignore either.”

If the US missed a payment on a short-term note due in June, for example, it would spark an outcry in the markets, accompanied by extreme volatility for a day or two, Hollenberg explains, and then the debt ceiling impasse would likely come to an end.

“When you reach a crisis, that tends to put the political gears in motion,” he adds. “If that happened, I think Congress would very quickly come together and raise the debt limit, and investors would be made whole.”

The law of unintended consequences

That doesn’t mean there would be no consequences for a technical default. The rating agencies could slash the US credit rating again. Investors could drive up the cost of future US debt issuances. And, perhaps worst of all, some investors may no longer regard US Treasuries as the safest investment in the world.

“We don’t really know what the downstream implications would be,” Hollenberg says. “For example, there are banks whose ratings are somewhat linked to US sovereign ratings. There are insurance companies in the same situation, as well as agencies like Fannie and Freddie. It’s difficult to know what would happen to them if one or more of the rating agencies were to downgrade the US again.

“We could wind up with cascading downgrades, and that would be a real problem for some financial institutions,” he warns. “It’s not something we can just gloss over, and it’s why we need a timely resolution. I do think we will get one, I just hope it comes before we encounter any unintended consequences.”

How much debt is too much?

From the point of view of an equity investor, the US debt ceiling debate makes for interesting political theater, but it’s not something that weighs too heavily on investment decisions, says portfolio manager Steve Watson.

“At the same time, I don’t think it’s necessarily a bad idea to have an occasional reminder that the United States is more than $30 trillion in debt,” Watson notes. “Maybe it’s time to engage in a serious discussion about long-term fiscal responsibility.”