It’s back to school season and the City is preparing to wake from its summer siesta. In the UK and over the pond, policymakers will return to their desks to deal with the decisions put on hold over the holidays – spare a thought for the poor Brexit negotiators short-changed with their annual leave. Priority number one: the US debt ceiling.
Rhetoric is already heating up as ratings agencies warn that a failure to raise the US debt limit will leave the markets battered and bruised in weeks.
What is the US debt ceiling?
In a bid to keep its finances in check, there’s a cap on the amount America can borrow – which essentially means there’s a limit to how many bonds the US can issue to fund its operations.
Set up 100 years ago, this isn’t the first time the US has hit its limit. Congress has intervened around 80 times since 1960, either by raising the cap, implementing a temporary extension, or revising the terms of the limit.
In November 2015, Congress suspended the US debt ceiling – only lifting the suspension in March this year.
The US Treasury has resorted to “extraordinary measures” since to ensure it’s meeting its obligations without breaching this threshold. This debt issuance suspension period, as it’s known, will expire on 29 September. The US really needs to have raised the ceiling by then.
What will happen if the US doesn’t raise its debt ceiling?
If the US can’t issue any bonds to raise any new money, interest payments to existing bond holders could be missed, meaning the US will have defaulted on its debt.
Ratings agency S&P Global has dramatically warned that a failure from Congress to raise the debt ceiling could be “more catastrophic” than Lehman Brothers’ collapse in 2008.
Another credit ratings firm Fitch has said it will review its triple-A rating for the US if it fails to raise the debt cap. A ratings downgrade might make US debt more expensive.
A default would force the US to cut its spending, which could push the country back into a recession, causing havoc on the markets and hitting investors where it hurts. As ever, it’s hard to say just how much of this is already priced into investments.
The bond market is showing signs of stress; bonds expiring in mid-October have higher yields than those that expire in September. Nervous investors could cause trouble on the markets as they sell up to protect their money.
This is worrying for the UK – remember, the US economy has a tight grip on the rest of the world. ‘When America sneezes, the world catches a cold’, as the saying goes.
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Our strong trade relationship means that a US recession would have serious consequences on the UK business and the economy.
The interesting question for me is one around volatility; will hitting the debt ceiling be the straw that finally breaks the camel’s back?
Volatility levels have been at historic lows, despite a backdrop of uncertainty. Threats of nuclear war, an unstable White House rota, rising tensions between America and the Kremlin, natural disasters and human disasters all should, theoretically, make investors nervous.
Yet nobody has been paying attention. Granted, volatility levels – as measured by the VIX – lifted off its record lows in August, but look at the long-term and volatility still looks relatively flat.
Investors are probably feeling confident that the Central Bank is on hand to step in should it need to as inflation is still relatively low. Only time will tell if they’ve judged this right.
For context, volatility has an average of 12 over 12 months, 16 since 2010, and 20 over the last decade. The VIX has only broken above 40 a handful of times; in 1998, 2002, 2009 and 2011.
Should you increase risk?
Despite the doomsayer’s commentary, the US is widely expected to raise the debt ceiling by mid-October. This won’t stop investors’ relief, which could feed through into the market.
With fears that the US is going to run out of money extinguished, volatility levels could remain low. But does that mean you should increase the risk in your investment portfolio?
Despite the doomsayer’s tone, the US is widely expected to raise the debt ceiling by mid-October, which means volatility levels could keep to its current trend. But does that mean you should increase the risk in your investment portfolio?
Your primary focus when investing is doing so in a way that’s right for you. You need to know what you’re saving for and when you’ll want your money, as this will impact what you invest in.
If you’re in a position to take on more risk, don’t jump in with two feet. Take your time to understand what you’re investing in – timing the market rarely works, you should be growing your money for the long-term, anyway.