Debt Ceiling: Lessons from the 2011 Budget Debate

Oct 22, 2023

The House of Representatives and the White House appear to be locking horns over the Federal budget and on raising the debt limit that could potentially delay coupon and principal payments on U.S. Treasury issued Bills, Notes and Bonds. The Congressional Budget Office suggested in mid-February that the government could run out of cash between July and September. The amount of tax revenues received in April could bring the date forward or push it back within the three-month range. Regardless, Q3 2023 could be fraught with challenges for investors in U.S. government securities as well as in equities, gold and other assets.

So, if the budget debate in Washington comes down to the wire, what should investors expect? While there have been several government shutdowns over the past few decades including in 1995-96, 2013, and 2018-19, only during the summer of 2011 did the possibility of default come to the fore. Looking back at the summer of 2011 can be instructive for investors in terms of how different markets reacted at the time. However, it's important to note that economic and financial conditions in 2011 were very different than they are today. As such, even if the current budget debate were to take a similar course to that of 2011, there is no guarantee that investors’ response would be similar.

Before we get to 2011, it is important to note the difference between a a government funding crisis and a debt ceiling breach. A funding crisis creates a partial shutdown of non-essential government services – with the potential for about 800,000 employees to be furloughed. When the funding deal is finally approved, workers get back-pay. The debt ceiling issue is different. Tax revenues will make up approximately 80% of what the Federal government needs to meet its expenses. However, the U.S. Congress has never provided the executive branch with legislative direction as to who to pay first.

Individuals, when faced with a shortage of cash and credit lines, typically pay their mortgage and car loan first. If something must be skipped, it will be student loans and credit card payments. The government, though, has no priority list. Do they pay military and veterans and not pay Social Security, Medicare and Medicaid, or do they prioritize paying investors with maturing T-Bills/Bonds or the coupons on Treasuries? The absence of prioritization leaves open the possibility that nobody will get paid. As such, a debt default isn't only about bond investors which makes a potential debt default potentially much more impactful for consumer spending, business investment and overall economic activity than a government shutdown.

The situation in the spring and summer of 2011 has certain similarities to the present:

One might have imagined that the possibility of default and the reality of a downgrade would have driven U.S. Treasury prices lower and yields higher, but the opposite occurred (Figure 1). In the lead up to the budget crisis, 10Y U.S. Treasury yields were already falling, from a peak of 3.73% in early February 2011 to 2.94% by July 28. They then fell by an additional 122 basis points (bps) to 1.72% by late September. 30Y U.S. Treasury yields fell by a similar amount. By contrast 2Y yields didn't move as much, with yields falling from 0.85% in early February 2011 to a low of 15 bps by mid-September. What drove Treasuries lower was a flight-to-quality from the equity markets.

From its peak at the end of April 2011 to its low in early October 2011, the S&P 500® shed 19.4% of its value in what would be one of the deepest corrections in prices during the 2009-2020 bull market. Small and mid-cap stocks fared worse, with the Russell 2000 losing 29.6%, the S&P MidCap 400 falling 26.6% and the S&P SmallCap 600 losing 26.7%. The tech-heavy Nasdaq 100 was the outperformer, losing a relatively low 16.1% peak to trough (Figure 2).

The various sector indexes all fell during this period but in highly varying degrees. Among the hardest hit were the various financially related indexes including regional banks, financials, and insurance. The relative outperformers included consumer stocks (discretionary and staples), information technology, health, retail and utilities (Figure 3).

Financial assets weren't the only ones that moved. With the dollar's value called into question, gold prices soared $400 per ounce from $1,482 to $1,890 between July 1 and August 22, 2011, a 27% rise.

Despite the superficial similarities between 2011 and 2023, there are plenty of differences. For starters, the political actors in Washington are not the same, with a different President and Speaker of the House etc. As such, the political events could turn out much differently this time. Secondly, market reactions are a function of many factors including the evolution of events, how those events are perceived by investors and the starting conditions in the markets themselves. In 2023, the starting conditions in markets are very different than in 2011.

1) With respect to the fixed-income markets, in 2011 the Fed had rates in the range between 0-0.25%, and was conducting quantitative easing (QE). Zero rates likely prevented much of a rally in short-term rates while QE may have encouraged the flight to quality into longer-term bonds.

In 2023, the situation is largely the opposite. Currently, Fed Funds is in the range between 4.75%-5.00% and investors are pricing a significant likelihood (81.5% according to CME Fed Watch Tool as of April 14, 2023) that the Fed takes rates up to 5.00%-5.25%. As such, unlike in 2011, this time around the Fed has plenty of room to cut rates if needed. This may partly explain why the yield curve today is inverted as opposed to being positively sloped at this time in 2011. Additionally, the Fed is currently doing quantitative tightening (QT), allowing its bond portfolio to roll into maturity without purchasing news bonds further up on the curve. This is essentially the opposite of QE.

2) Equity valuations are much higher today than they were in 2011 (Figure 4). When the market peaked on April 29, 2011, the S&P 500 market cap was 79% of GDP. By October 3, 2011, it had fallen to 62%. As of April 14, 2023, the S&P 500 market cap amounted to 141% of GDP, roughly twice its 2011 levels. As such, it's easy to imagine high valuation levels amplifying any downside move. This may be especially true for tech stocks, which were depressed in 2011 but highly valued in 2023.

3) In 2011, inflation was low and stable at around 2% (as it had been since 1994 and would be through Q1 2021), while unemployment was very high at around 9%. Today, unemployment is at 3.5% while core inflation is 5.6%, still significantly above the Fed's target. This could make it very difficult for the Fed to cut rates or otherwise ease policy without upsetting bond investors who might perceive any budget-debate related policy easing as a step back from fighting inflation.

Finally, the budget situation is different in 2023 than in 2011. Going into the 2011 budget debate, the Federal budget deficit was around 9.3% of GDP and was in the process of shrinking towards 8% by year's end. It would eventually diminish at 2.5% of GDP by 2016 as the economy grew, and after the Bush and Obama tax cuts expired at the end of 2012. Extremely low rates in 2011 and reduced debt servicing costs were helping to shrink the budget deficit as the Federal government borrowed nearly for free at the short end of the yield curve.

As of March 31, 2023, the Federal budget deficit was 7.1% of GDP, smaller than in 2011, but rapidly widening. Between July 2022 and March this year the deficit rose from 4% to 7.1% of GDP (Figure 5). Higher interest rates have sent the Federal government's cost of borrowing soaring. Moreover, public debt now amounts to 113% of GDP compared to 87% of GDP in 2011.

In short, 2011 offers just one data point on how markets could respond to the possibility of a temporary default on U.S. government bonds. That particular set of events coincided with a wave of volatility in bonds and equities that included a significant sector rotation. It does not, however, provide us with a roadmap as to how markets might respond if the Federal government actually does begin to miss payments on Federal debt since that didn't actually happen in 2011. Moreover, as discussed above macroeconomic, budget and market conditions are very different in early 2023 than they were in 2011 and in ways that suggest the potential for amplified volatility this time around.

The resolution of the debt ceiling debate is about politics, and it is complicated. Essentially, the actors on both sides of the aisle have their eyes on the 2024 Presidential and Congressional elections. Who will get the blame if there is a breach of the debt ceiling? There are many newly elected members of the House majority that won narrow victories in swing districts, especially in the Northeast. Could the resolution of the debt ceiling debate swing these House seats one way or the other? As such, investors in equities, fixed income and gold will likely be watching the political winds more and more closely over the next few months. And those winds can shift direction quickly.

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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.