Key takeaways:

• The US government is working to raise the debt ceiling in order to avoid the prospect of a devastating default that could prompt higher borrowing costs, consumer pain, job losses, and a recession

• In 2011, the US averted a similar default by just two days, however, the stock market was still sold off sharply amid a credit rating downgrade and spending cuts

If you've been listening to news out of the United States recently, one of the major talking points is negotiations to raise the debt ceiling. 

Politicians are frantically racing to avoid the prospect of the US government defaulting on its debt as early as the start of June - something that would undoubtedly wreak havoc across the economy and financial markets. 

But what is the debt ceiling all about? Let take a closer look at what it means for investors.

What is the US Debt Ceiling?

The debt ceiling is the amount of money the US Department of Treasury is authorised to borrow to pay for the country spending obligations. It does not authorise new spending commitments, rather, it allows the government to finance existing legal obligations.

As an example, the debt ceiling covers interest on outstanding debt, social security benefits, medicare, military salaries, and much more.

Currently, the US debt ceiling sits at US$31.4 trillion.

How does the US Debt Ceiling Work?

Earlier this year, the US reached its debt ceiling. That has prevented the government from increasing its debt capacity, in turn making it more difficult for the government to pay its bills. 

Think of the situation as being similar to an individual who has maxed out the credit on their credit card.

Of course, the debt ceiling would be less of an issue if the government were able to cover its spending commitments solely through the income it generates - in the same way that households wouldn't need to turn to credit cards if their income comfortably covered their expenses. 

Nonetheless, the US has been running an annual deficit for the last 22 years, with borrowing making up the shortfall every year since 2001.

By now you're probably wondering how the US has avoided a default if it hit the debt ceiling back in January?

The US Treasury can resort to other methods to effectively kick the can down the road. Naturally, it may spend incoming revenue or use cash on hand. But the preferred method this time was extraordinary measures allowing the government to shift funds around to free cash for short-term government spending.

Another option is to suspend the debt ceiling, at least temporarily, and then reinstate it at a higher limit, which is practically a retroactive increase. During suspension, the government is free to borrow money to pay for plans.

What is a Default?

As mentioned above, the US has thus far managed to avoid a default despite already reaching its borrowing limit. This is because a default would occur if the country failed to fulfil its financial obligations. In this respect, if the government ran out of money to meet its commitments, it would be defaulting on its obligations.

These obligations are not necessarily just trade partners, taxpayers, and government functions. For example, investors who hold US Treasury bonds receive periodic payments in exchange for providing money to the government to run the country.

While the US goes some length to emphasise that it has never defaulted on its debt - at least, intentionally - economists and historians will tell you there have been a few examples over the last 160 years where the government technically defaulted on its debt.However, these instances are often dismissed as being a true default because rather than being unable to pay, the US government instead changed the terms for bondholders. On one occasion, an equipment glitch meant payments to a small number of individual investors redeeming Treasury bills were delayed.

What Happens if the US Defaults?

US politicians are currently scrambling to raise the debt ceiling because the extraordinary measures mentioned above are no longer able to buy the government more time to meet its repayments. As it stands, the government can no longer borrow money.

An exact deadline for default is hard to define due to the timing of government payments and revenue. However, the US Treasury is on record as saying that it is "highly likely the agency will be unlikely to meet all of the government payment obligations by early June, potentially as early as June 1, 2023, if the debt ceiling is not raised beforehand. If by that date the debt ceiling has not been increased, it is anticipated the government may default on its debt. Some Wall Street analysts believe the true date for when the government would miss a payment is likely to be June 8 or 9.Since the US has never experienced a true default, the fallout of such an event is untested. Economists are all in agreement that the ramifications would be significant for the US economy, and for that matter, the rest of the world.

More than US$500 billion of US debt is traded around the world every day, with much of that held by foreign investors and governments. A default would increase the relative risk appeal of investing in US debt, which could prompt credit rating groups to downgrade the country credit rating. 

If this transpired, it would almost certainly result in higher borrowing rates for the US to borrow money from foreign markets. It would also likely lead to heavy job losses. Those threats could be enough to cripple the economy and bring about a recession.

US debt ceiling negotiations are not uncommon. In fact, since 1960, US Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit. It has never reduced the debt ceiling.

On a number of occasions, and as is the case in 2023, both sides of the political aisle are seeking concessions from the other before agreeing to amend the debt ceiling. The two parties have made a list of demands that they see as necessary to proceed with a deal to either raise or suspend the debt ceiling. 

How Might the Debt Ceiling Affect the Stock Market?

There are a number of implications for the stock market depending how debt ceiling negotiations unfold.

Back in 2011, similar negotiations resulted in a protracted episode where the debt ceiling was raised just two days prior to the Treasury estimate for when the country borrowing authority would be exhausted. 

Despite reaching a deal, the stock market was rocked with the most volatile week of trading since the Global Financial Crisis. The S&P 500 slumped 17% between July 22, 2011, and August 8, 2011. 

Bond prices leapt as investors sought safe-haven' assets. Investors digested spending cuts across the economy. Standard & Poor downgraded the United States' credit rating for the first time in its history. Delays in raising the debt ceiling were ultimately deemed to raise borrowing costs by billions of dollars.

The above suggests that even if a deal is reached, if the United States were to incur another credit rating downgrade, stock market volatility could resurface.

As discussed earlier, the failure to reach a deal in time would have an even bigger impact for the economy at large, especially if the default turns into a prolonged affair.

For starters, the government would be forced to prioritise its bills. It is conceivable that bondholders would receive payment ahead of households that receive federal benefits. Delays for households, even modest ones, would lead to significant issues for millions that depend on these funds to make ends meet. There could also be an impact on government functions like the defence force.

With less cash going into the economy, and consumer sentiment sure to suffer, the odds of a recession would increase dramatically. Major job losses would be a prospect at that point, and higher borrowing costs would be passed on to consumers and businesses.

Investors will be hoping a default can be avoided because the shock wave of such an event would reverberate throughout credit markets across the world and impact global stocks. The US Council of Economic Advisers estimates the stock market could nosedive 45% in the third quarter of the year in the event of a protracted default. 

With time ticking, investors will be watching events closely.