Among the most basic responsibilities of Congress is appropriating funds to operate the federal government. Another is ensuring that the United States does not default on its debts.
Yet these and other fundamental obligations have become the focus of bitter partisan battles that regularly remain unresolved until the very last minute—or beyond. The uncertainty roils the markets and provokes investor anxiety.
This fall, Washington is readying itself for another round of fiscal brinkmanship. Congress will once again either have to strike an agreement to fund the government or risk a shutdown. Lawmakers also face a deadline to raise the debt ceiling and avoid a default.
The news media will likely make much of this, issuing warnings of impending economic disaster. But should these disputes raise concerns among investors? That remains to be seen.
Broken budget process
The congressional budget process is a cumbersome one, to say the least. It begins with the president making a budget proposal, which is usually unveiled in February. This document is essentially symbolic, serving to highlight the White House’s policy priorities.
Congress then develops its own plan, known as a “budget resolution,” which provides a broad framework for government spending. Next, the appropriations committees in the two chambers fill in the details, allocating funds on an agency-by-agency and program-by-program basis. There are 12 appropriations bills, each of which must be approved in identical form by both the House and Senate and then signed into law by the president. Congress is supposed to complete this task before the government’s fiscal year begins each October 1.
When Congress misses this deadline, it resorts to “continuing resolutions” to fund the government while lawmakers try to finalize the appropriations bills.
Where do things stand now?
With Republicans now in control of both chambers, Congress was able to approve a budget resolution earlier this year. However, passing the appropriations bills remains difficult. Congress hasn’t succeeded in passing all 12 bills on time since 1996.
Congress failed to pass a single appropriations bill in 2014. Legislators used a series of short-term continuing resolutions to keep the government operating through the election in November. In December, Congress finally agreed to a longer continuing resolution that funded the government for the remainder of fiscal year 2015, which ends September 30. Unless Congress can agree to a new measure, a government shutdown looms on October 1.
Should investors be concerned? We think the chances of another government shutdown are relatively low. Congress will likely want to avoid a repeat of the 16-day shutdown in 2013 since both parties drew public ire for their inability to reach consensus.
However, that doesn’t mean a long-term solution is likely. So get used to hearing the phrase “continuing resolution,” because Congress will undoubtedly have to resort to a series of short-term agreements to keep the lights on.
Debt ceiling debacles
In the coming weeks, lawmakers will also face a deadline to increase the government’s debt ceiling, which currently stands at about $18.1 trillion. This number represents the amount of debt the Treasury Department can issue to pay for things like Social Security, military salaries and interest on the national debt. When Congress raises the ceiling, it isn’t authorizing new spending. It is just allowing the Treasury to finance its existing commitments.
For decades, increasing the debt ceiling was a routine matter. Only in the last 10 years or so has it become controversial. Some cite the ceiling as evidence that politicians can’t control spending.
Where do things stand now?
After repeatedly clashing over whether or not to raise the ceiling, Congress agreed in February 2014 to simply suspend it altogether. That agreement ended on March 15 of this year, so the ceiling was reinstated—at the current level of outstanding debt. Unable to borrow more, the Treasury immediately began employing so-called “extraordinary measures”—such as suspending issuance of state and local government securities and making changes to how federal retirement funds are invested, among other actions—to avoid default.
Extraordinary measures are basically accounting techniques designed to buy Congress time, usually from a few weeks to a few months, depending on other economic conditions. But they are not a permanent solution.
The Congressional Budget Office has estimated that the Treasury could run out of cash by the end of the year. What happens if Congress can’t agree on an increase? You may recall that in August 2011, Congress brought the country close to its first default after failing to raise the ceiling. The uncertainty caused the S&P 500® Index to drop 13% in the first week of August 2011. The market reaction eventually helped push lawmakers into an agreement to increase the debt ceiling.
So what are the odds of another showdown this time?
A growing number of conservative Republicans have refused to support any increase in the debt ceiling in recent years. Another group of Republicans have said they will support a debt ceiling increase only if it is paired with a corresponding amount of spending cuts, which President Obama has rejected. Meanwhile, Democrats are threatening not to help Republicans pass a debt ceiling increase this year.
The path forward remains uncertain, and a long-term solution that would help lower the nation’s accumulated debt continues to be elusive. Some have proposed eliminating the debt ceiling entirely, or at least changing it. For now, we’re stuck with the current process.
Takeaways for investors
As this fall’s drama unfolds, investors could see some market volatility. But that’s no reason to panic. Looking back to the debt ceiling crisis of 2011 could give us some insight into what markets might make of another congressional showdown.
As mentioned above, the S&P 500 notched a 13% decline during the first week of August 2011. That was just the start of what would eventually be a 20% drop, accompanied by a rise in volatility. As we now know with the benefit of hindsight, that plunge created a spectacular buying opportunity for equity investors.
The situation in the bond market was another story. Courtesy of anxious investors fleeing to the perceived relative safety of U.S. government bonds, Treasuries rallied quite sharply even as the country faced a potential default. This happened despite pundits’ warnings that a possible debt default, and related downgrade of the United States’ credit rating, would lead to soaring Treasury yields.
Why did this happen?
- When all else is going wrong, investors still flock to U.S. Treasuries. The prospect that the government might be shut down raised the risk of an economic downturn as public spending dried up. The economy wasn’t very strong at the time, so the extra drag on growth could have risked tipping the economy into a recession. Demand for bonds from concerned investors may have helped pull down yields.
- Some also thought the Federal Reserve would go out of its way to pump liquidity into the financial system to offset the impact of a contracting government sector.
- Some simply didn’t believe Congress would let the worst come to pass. With the stock market falling and uncertain economic outlook, investors assumed the government would make good on its promises. After all, it wasn’t unable to pay its bills, just unwilling.
Of course, this isn’t to suggest that history will repeat itself this fall. But it may still be reassuring to know that financial markets weathered the last major showdown in Washington.