News about an impending debt ceiling crisis has been everywhere. But now Congress has passed the “Fiscal Responsibility Act,” which raises the federal debt limit. The agreement only holds until 2025, and then we start all over again. Even if this contemporary threat didn’t panic investors this time around, it will return multiple times during any Financial Professional’s career, so it’s important to understand the implications of exceeding the debt limit both for investments and the psychology of those who hold them.
What exactly is the debt ceiling and why do we care? The debt ceiling refers to the maximum amount of debt that the U.S. Federal Government is allowed to take on through the issuance of Treasury securities. Congress sets this limit under its constitutional authority to tax, spend, and borrow money from around the world. So long as total federal debt is below this limit, the Treasury Department can issue bonds that pay for mandatory (e.g., Social Security) and discretionary (e.g., defense) spending as well as interest on existing debt.
If the U.S. government approaches or hits the congressionally-imposed debt limit, however, and the Treasury Department exhausts all extraordinary measures to keep the government funded, a sequence of consequences will ripple across financial markets, the economy, and a broad swath of the population. Extraordinary measures are accounting techniques that allow the U.S. to continue meeting its financial obligations without issuing additional debt and breaching the ceiling. However, these measures only provide temporary relief, and once they're exhausted, the government risks running out of cash to meet its financial obligations, leading to a potential default.
How would a debt ceiling crisis affect money market funds? Even though these funds are thought of as extremely safe, a crisis could significantly impact their risk profile, liquidity, yield, and ability to preserve capital.
A default is a serious event that could have severe consequences for the U.S. economy and financial markets. The U.S. government bond market, considered the safest asset class globally, could be destabilized. This would lead to a sharp increase in interest rates as investors demand higher yields to compensate for the increased risk, thus raising borrowing costs for consumers and businesses and almost certainly leading to an economic recession. Additionally, a debt ceiling crisis can cause dramatic volatility in stock markets as investors reassess the risk profile of their portfolios and react to uncertainty. If the government cannot service its debt, payments for various services, including social security, military salaries, and others, could also be disrupted.
One of the great questions we’ve received from Atlas Point customers is how this might affect money market funds that invest in high-quality, short-term debt instruments. These funds are favored by investors for their safety, liquidity, and modest yields. Even though these funds are thought of as extremely safe, a debt ceiling crisis could significantly impact these funds’ risk profile, liquidity, yield, and even ability to preserve capital.
With all this risk, a debt ceiling crisis can create a high-stress financial environment that could lead to irrational behavior among investors. This irrational behavior can manifest in several ways.
FPs are in a unique position to help clients navigate through times of financial stress, such as a debt ceiling crisis, and avoid irrational behaviors. Here's how:
Effective Communication. Regularly inform your clients about the market situation, explaining the implications of the debt ceiling crisis in simple terms. Reassure them that these situations have historically been resolved without long-term damage to the economy. Clear and timely communication can help prevent panic and overreaction. Even though short-term market movements can be dramatic, they often have minimal impact on long-term investment outcomes.
Personalized Advice. Remind your clients about their individual investment goals and risk tolerance. Encourage them to make decisions that align with their personal objectives rather than following the crowd.
Reinforce the Benefits of Diversification. Stress the importance of maintaining a diversified portfolio as a risk management strategy. Explain how staying invested in different asset classes, including money market funds, can provide a level of protection during market volatility.
You can also use our Financial VirtuesTM survey and Pulse ChecksTM to determine which clients may be most prone to the biases discussed above. For example, our Financial VirtuesTM survey provides insights on the extent to which each of your clients may display herding or loss aversion. This level of information allows FPs to provide more personalized recommendations and have deeper conversations with their clients regarding financial plans and decision-making.
In essence, your role as an FP is crucial in helping clients avoid irrational behaviors during a debt ceiling crisis or any other period of financial stress. By providing clear communication, personalized advice, and proper education, you can ensure your clients’ investment strategies remain robust and aligned with their long-term goals.
We don’t know if the debt ceiling will reach a crisis point again in 2025, but the chances of exceeding the limit once the Fiscal Responsibility Act expires remain low. What is far more likely is that the fear, uncertainty, and misunderstanding of investors could lead to drastic and costly decisions in anticipation of a financial disaster very unlikely to occur.