Washington Policy Fights Pressuring Markets

MIKE TOWNSEND: If you stay in Washington for long enough, it's pretty easy to suffer from déjà vu. Some issues never seem to go away.

Take the debt ceiling stalemate that we are in right now. It looks a lot like the debt ceiling battle of 2011. Or 2013. Or 2021. Or 1995. Assuming a deal gets done in the coming weeks, it will be the 79th time Congress has raised the debt ceiling since 1960. And it's far from the first time that investors have been left guessing about when and whether lawmakers will raise the limit.

Or take the latest banking turmoil. A couple of bank failures, a forced sale of a struggling bank to JPMorganChase, regulators on the hot seat for lax supervision―sounds a lot like the 2008 financial crisis.

For investors, it's never a good thing when what is going on in Washington is dominating the market headlines―because it usually means something is on the brink of going very wrong.

And once again, company earnings and the state of the economy and all of the important factors that investors take into account when making investing decisions have taken a backseat to another period of manufactured drama in the nation's capital.

Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I'm your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to.

Today, I want to do something I try to do every few months, and that is to focus an episode on answering some of the most frequently asked questions I've been getting when I speak with investors.

And not surprisingly, the biggest topic for investors right now is the debt ceiling and the possibility that the United States will default on its debts for the first time ever. So I want to answer a few questions about where we are, what the possible outcomes look like, and what happens if we actually default.

The state of play with the debt ceiling is very much a moving target, but here's a quick review of where things stand.

We hit the debt ceiling of $31.4 trillion back in January. Since then, the Treasury Department has been taking what it calls "extraordinary measures," which are a series of accounting maneuvers it employs to make sure the United States does not default on its debts.

President Biden met with House Speaker Kevin McCarthy on February 1 to discuss raising the debt ceiling―but there were no further meetings for more than three months.

Meanwhile, the House, where Republicans hold a four-seat majority, passed a debt ceiling bill on April 27 that would raise the limit by $1.5 trillion or until the end of March of 2024, whichever comes first. That bill included a number of Republican priorities, including nearly $5 trillion in unspecified federal spending cuts over the next 10 years, the claw back of unspent COVID-19 funds, the repeal of several provisions of last year's Inflation Reduction Act, reforms to the permitting process for energy projects, and tougher work requirements for recipients of food stamps and Medicaid.

Just a couple of days later, on May 1, Treasury Secretary Janet Yellen sent a letter to Congressional leaders in which she said that the country could default as soon as June 1 if Congress did not raise the debt ceiling.

The president met on May 9 with the top four congressional leaders. No breakthroughs were announced, but staff level meetings have been ongoing, and the five principals met again at the White House on May 16.

One of the big questions for everyone―for investors, for the negotiators―is when a potential default will actually occur.

While Secretary Yellen's letter to Congress earlier this month did state that the default could be "potentially as early as June 1," in the very next line it went on to say that because estimates of federal receipts and outlays are inherently variable, "the actual date could be a number of weeks later …"

On May 13, the nonpartisan Congressional Budget Office released its own analysis, indicating that there is "significant risk" of a default in early June. But the CBO also included a major hedge in their analysis, echoing Yellen's comment that the volatility in payments and receipts at Treasury could push the default date out further.

One of the key contributors to the uncertainty is that there are dates coming up next month that could―if we make it to those dates without defaulting―make it easier to push the default date later into the summer. The first is June 15, which is when quarterly tax payments are due. Those payments will provide a short-term spike in funding to the Treasury and could take us to the next important date, June 30.

That's when an estimated $145 billion in additional "extraordinary measures," related to suspending reinvestments of maturing assets in certain federal pension funds, become available for the Treasury to take. Utilizing those funds could give the Treasury breathing room well into July.

So there is a lot of uncertainty here, and it's inherently frustrating to everyone―but particularly to lawmakers, who are trying to hammer out a deal but don't know what the true deadline is for raising the debt ceiling.

Congress tends to delay action until the pressure is really on and a deadline is bearing down on them, so members of Congress are really looking for a hard, specific deadline here―and that's true for just about any issue. Washington is notorious for cutting lots of deals and passing lots of big bills every year in mid-December. Why? Because it's said that the most powerful deadline of the year for Members of Congress is making sure that they are home for the holidays.

But Secretary Yellen reiterated on May 15 that she was not changing her estimate that the U.S. could default on or around June 1. Her most recent comments were disappointing to those on Capitol Hill who have believed all along that she was playing political games with the default date, simply to keep pressure on the negotiations. Yellen did say that she would provide another update next week.

In the meantime, the focus on reaching a deal will continue. The timing is incredibly important―and incredibly challenging. President Biden left on May 17 for a trip to the G-7 summit in Asia. The Senate is scheduled to be in recess the week of May 22. And the House is scheduled to be in recess the week of May 29. Now all three could and would change their plans if they had to be in Washington to debate and vote on and potentially sign a bill. But they have to reach a deal first, and progress on that front remains agonizingly slow.

Without a doubt, the most frequent question I've been asked in 2023 is: Do I think they will reach a deal and lift the debt ceiling before the default date?

Call me an optimist, but I continue to think that default is unlikely, although I freely admit that the odds of default are rising. The fact of the matter is that Congress has never allowed the country to default. And when push comes to shove, I don't think this Congress really wants to be the first one to test out what happens.

But it's also true that this may be the most divided Congress we've ever had, and it remains difficult to see how the two parties get to something, anything, that both can support. Since the beginning of the year, the two parties have had completely different goals. Democrats want a clean debt ceiling increase with no strings attached. Realistically, though, that can't pass either the Senate, where it would need a 60-vote supermajority, or the House, where Democrats are in the minority.

Republicans all along have said that they would only support a debt ceiling increase that is paired with spending cuts. With their slim majority in the House, Republicans have passed their bill to do that. But it can't pass the Democrat-controlled Senate. And thus the standoff.

Yet if you squint, you can see the vague outlines of a compromise. Democrats appear to be willing to claw back some of those unspent COVID-19 funds. And both parties want energy permitting reform―it's just a matter of hammering out the details. Spending cuts, I think, are inevitable as well―at this point it's about finding a middle ground that allows both sides to say that they have won the debate.

And a third question on the debt ceiling is, are there alternatives? We've talked before on this podcast about some of the alternative ideas that have been floating around―minting a trillion dollar coin is one that gets a lot of press attention, but which has been repeatedly dismissed by Treasury officials of both parties as an unrealistic gimmick.

Offering so-called "premium bonds" has been getting a bit of buzz recently―these bonds would extend the life of bonds that are already issued, but at a higher rate. But many skeptics see this as another gimmick that is legally questionable and would be difficult for the Treasury to launch on short notice.

Another alternative that has been attracting more attention recently is whether the president can invoke the 14th amendment to unilaterally ignore the debt limit. Is that a real option?

The key passage is in Section 4 of the 14th amendment to the U.S. Constitution, which says that "the validity of the public debt of the United States … shall not be questioned."

Legal scholars have been arguing for years about whether this language could be relied upon by the White House to simply bypass Congress and direct the Treasury to continue paying debts, even if Congress has not raised the debt ceiling. But there's a real dispute about whether this would be permissible.

The president said last week that he is "considering it." Treasury Secretary Janet Yellen has been more skeptical, calling it "legally questionable."

Most experts believe that invoking the 14th amendment would immediately trigger a court challenge, which itself would produce a period of uncertainty that could roil the markets and hurt the economy while the courts consider the issue.

It's that uncertainty that makes it unlikely the president would go down this path. But leaving it open as a possibility is something the president can potentially use as leverage if negotiations stall in the next couple of weeks.

And that leads me to the biggest concern most investors have right now: What happens if Congress can't reach an agreement in time?

Now, it's important to say at the outset that there is no official answer to this question. The Treasury Department has been planning for this possibility but won't say publicly what the department would do. A big reason for that is because the Treasury doesn't want to leave anyone―particularly lawmakers on Capitol Hill―with the idea that defaulting would be something that the Treasury could just handle with ease. That risks reducing the pressure on Congress to act.

It is widely assumed that if the worst-case scenario came to pass, Treasury would prioritize ensuring the stability of the Treasuries market. As the world's largest bond market, disruption in the Treasury markets would have worldwide reverberations. During the debt ceiling crisis of 2011, Federal Reserve meeting minutes indicate that planning scenarios for a potential default assumed that "principal and interest on Treasury securities would continue to be made on time." Secretary Yellen―who was Fed vice chair at the time―has said repeatedly that those plans were never agreed to as a way of signaling that nothing is set in stone on that count. And she went out of her way last week to say that she has not had discussions with the president yet on what to do if the ceiling isn't raised.

But assuming Treasury securities continue to be paid, what's next in the priority list is anyone's guess. Social Security payments and defense payments are likely in the next tier. But you would quickly enter the realm of impossible choices. What to do about salaries of federal employees? Pay veterans' benefits or air traffic controllers? There's just no playbook for how this would work, and Treasury doesn't actually have any authority to make these decisions.

There's also an operational issue with the antiquated systems at Treasury. It's not even clear that Treasury could prioritize payments, because the system is programmed to pay the bills as they come due―and there's no mechanism to pay one set of payments but not another.

A key question for investors who hold Treasuries that mature on or just after the default date is whether they will get paid. According to the team at the Schwab Center for Financial Research, there is a chance that those repayments are delayed.

As a result, there is currently a huge premium to own T-bills that mature before June 1, since there's a much higher certainty of an on-time payment. Treasuries that mature on May 30 currently have a yield of about 3.25%, while Treasury bills that mature on June 13 have a yield of 5.5% due to concern that they won't be paid on time.

We expect long-term Treasury prices to rally, since any default would likely be short-term and would not impact Treasury's ability to repay a note that matures years down the road.

Once the debt ceiling is raised, Treasuries that have matured will be repaid with interest, though it's not clear if they would pay any additional interest to cover any delay in repayment. Bottom line, Treasuries remain the most liquid and safest investments in the world.

Any kind of default would also have significant ramifications on the global markets and the global economy. And one of the issues that I've been asked about a lot recently is whether a default would lead to the U.S. dollar no longer being the world's reserve currency.

In short, we don't think so. Some of the speculation arises from news reports that China is using its yuan in commodity trades with some trading partners, or that Brazil and Argentina are exploring the development of a common currency. And there's concern that a default could exacerbate global concerns about the reliability of the dollar.

The dollar's share of global reserves has been gradually declining in recent years, but the operative word here is "gradually." The dollar represents about 60% of the world's reserves, a modest decline from 67% 20 years ago. The euro represents the second largest share at about 20%.

As my colleague Kathy Jones wrote recently, a reserve currency needs to be freely convertible and have deep and liquid bond markets to be considered safe for foreign central banks to hold. The United States has those qualities, and while other major countries' markets have these qualities, the size and openness of the U.S. market is unmatched. Our view is that there aren't really any viable alternatives, and that it doesn't look like anything is changing anytime soon.

Another question that I get about currencies is whether the United States is rushing to adopt a central bank digital currency. The question stems from an executive order issued by the president last year that said that the administration places "the highest urgency on research and development efforts into the potential design and deployment options" of a central bank digital currency. That has raised skepticism that the administration is trying to digitize the savings of ordinary Americans. Some in Congress have introduced legislation to prevent the Fed from developing a digital currency.

Fed Chair Jerome Powell was asked about this at a hearing on Capitol Hill in March, and he indicated that the Fed was nowhere near making a decision about whether to launch a digital currency at all, let alone what one would look like. And he indicated that it would require Congress to approve launching it.

To date, 11 countries, including China, have launched a central bank digital currency, and the United States is one of more than 100 other countries that are at different stages of exploring the idea. Until there is more widespread adoption of them, the pressure on the U.S. to move more quickly is not likely to increase.

Switching gears now to another topic I've been getting a lot of questions on recently is the ongoing uncertainty in the banking sector. Mid-size banks have been under enormous pressure since the collapse of Silicon Valley Bank and Signature Bank in March, followed earlier this month by federal regulators seizing First Republic Bank and selling it off to JPMorganChase.

Wary investors are keeping an eye on a handful of other banks that have experienced deposit outflows in recent months, though the stress in the system appears to be abating. At the same time, a lot of investors see opportunities in the banking sector, as financial institutions with strong fundamentals saw their share prices drop after the failures of Silicon Valley Bank and Signature Bank. Bargain hunters are snapping up bank stocks with significant upside potential at low prices.

But what about the Washington reaction to the banking turmoil? Are changes coming that could impact investors?

This was a big week for probing those questions. Congress held four high-profile hearings in a span of three days on the topic. The House Financial Services Committee and the Senate Banking Committee each held a hearing featuring testimony from former executives of First Republic Bank, Silicon Valley Bank, and Signature Bank, who tried to explain, not particularly successfully, what happened at their respective institutions that turned them from fast-growing success stories into the second, third, and fourth largest bank failures in history in a matter of weeks.

But the real action was at the other pair of hearings, where regulators from the Fed and FDIC, as well the top state banking regulators from New York and California, testified before both the House and Senate committees. In doing so, they admitted failures in their supervisory roles that contributed directly to the bank collapses, and they took bipartisan criticism for those failures from members of Congress.

Fed Vice Chair for Supervision Michael Barr outlined a plan to toughen regulations on mid-size banks, focusing on stress testing, higher capital and liquidity requirements, and more scrutiny of banks' management of interest-rate risk. He acknowledged multiple times that this would not be a fast process. By the time the Fed proposes rules, receives public comment, finalizes the rules, and allows for an ample transition time to the new rules, Barr said it would be several years before changes took effect.

And FDIC Chair Martin Gruenberg urged Congress in his testimony to strengthen the deposit insurance system―which insures bank deposits up to $250,000 per account―by recommending that business accounts that use deposits for payroll and other payments have a higher level of coverage.

Finally, the FDIC also recently proposed a special assessment that would impose increased fees on large banks in order to replenish the FDIC's deposit insurance fund. The fee would be 12.5 basis points on an institution's uninsured deposits. About $16 billion in the fund was used to cover all depositors at Silicon Valley Bank and Signature Bank―the goal of the fee is to refill the deposit insurance fund by the amount that was paid out to those depositors. The FDIC is exempting small banks from the assessment, so the fees will fall on about 113 mid-size and large financial institutions. If approved after a public comment period, those assessments would be applied on a quarterly basis for two years. Is it enough to weigh on the stock prices of financial institutions that will be paying the fee? Probably not―but along with the Fed's plans to tougher regulations on these bigger banks, it's a factor for investors to keep an eye on.

One final question I wanted to touch on is why there is so much controversy in Washington over stock buybacks.

At the heart of the issue is something of a philosophical question. Some policymakers believe that a company using its excess cash to buy back its own stock is a mechanism to drive up the stock price, rewarding executives whose compensation is mostly in stock. They say that the cash would be better used for investing in the company, doing things like upgrading equipment or hiring more workers.

But it's far from a universal viewpoint. Proponents of buybacks argue that buybacks are an efficient way to return value to shareholders, a sign of strong fundamentals, and a good indicator of a company's long-term prospects. No less an authority than Berkshire Hathaway CEO Warren Buffett wrote in his widely read annual letter to shareholders earlier this year that "when you are told that all repurchases are harmful to shareholders or to the country, or particularly beneficial to CEOs, you are listening to either an economic illiterate or a silver-tongued demagogue."

It's a debate that is raging in Washington. Last year, as part of the Inflation Reduction Act, Congress passed a new 1% tax on stock buybacks that went into effect at the beginning of 2023.

Early signs are that the new tax hasn't had much effect in deterring buybacks. Apple announced earlier this month that it plans to buy back $90 billion of its shares. Since 2012, the company has repurchased more than $570 billion of its stock.

The president, in his State of the Union address in February, proposed quadrupling the tax to 4%―something that is not happening in a divided Congress.

And earlier this month, the SEC approved new rules that would require companies to disclose more about share repurchases beginning in the fourth quarter of 2023. Companies will have to disclose daily tallies of their buyback activity during the previous quarter, report whether any executives made company stock transactions during the four business days before or after any buyback announcement, and they must provide a written rationale for any buybacks.

Nine days after the SEC finalized the rule, the U.S. Chamber of Commerce and other business groups filed a court challenge. So now the fight moves to the courts.

The takeaway for investors: So far, at least, none of these policy decisions in Washington have seemed to have much impact on companies' enthusiasm for buying back their own stock. But it's worth watching as more data is gathered.

Well, that's all for this week's episode of WashingtonWise. We're going to change up our schedule a little bit―normally our show comes out every two weeks, but we're taking a break during Memorial Day week. We're planning to be a little flexible at the beginning of June, depending on the status of the debt ceiling debate. So to ensure you don't miss an episode, take a moment now to follow the show in your listening app. And if you like what you've heard, leave us a rating or a review—that really helps new listeners discover the show.

For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.

I'm Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy and keep investing wisely.