How the US Debt Ceiling Will Impact the Stock Market

The financial news over the last few days has been dominated by one topic: The US debt ceiling.

You can be forgiven for thinking that the so called 'ceiling' of the US government debt is the most important event in the world right now.

But what is it really? And how does it impact the stock market?

Let's find out...

What is the debt ceiling?

The debt ceiling or debt limit is a statutory limit set by the United States Congress on the amount of national debt that can be issued by the Treasury Department.

It's the maximum amount of money that the US government can borrow to meet its financial obligations. Think of it as the credit limit on your credit card but for the US government.

So what is the point of the debt limit?

Well, just like most governments, the US government spends much more than it earns. This 'deficit' is funded by borrowing, which steadily increases the total stock of debt.

The idea of the debt ceiling or limit is to provide a legal means for controlling the government's power to borrow.

It's also a way to ensure that Congress i.e. elected representatives, have oversight over the nation's debt. Otherwise the US government could, in theory, recklessly spend any amount of money.

This 'ceiling' currently stands at US $31.4 trillion (tn). It has been raised or modified many times over the decades. Efforts are underway between the government and the US Congress, to negotiate another increase in the debt ceiling.

These talks have made a lot of progress and this has raised concerns of the US defaulting in its debt.

To understand that and its implications, let's quickly discuss how the debt ceiling works.

How does the debt ceiling work?

When the US Treasury Department borrows money to fund its deficit by issuing bonds. When the debt ceiling is reached, it can no longer do so. Thus, the US government will have to cover its expenses with only its revenues.

This is impossible as the US government will have a deficit of about US$ 900 billion (bn) this year.

Thus the debt ceiling can create a situation where the government is unable to pay its bills, potentially leading to a government shutdown or default on debt repayments, or both.

US Treasury Secretary, Janet Yellen, has warned that the US could default on its obligations in the first week of June, 2023. This is because at the current rate of spending, the US government will run out of money by around 1st June.

To avoid such a scenario, the politicians in the US Congress typically takes action to raise or suspend the debt ceiling when it nears or reaches the limit. This allows the government to continue borrowing and functioning.

Raising the debt ceiling does not authorise new spending but rather enables the government to meet its existing financial obligations.

Interestingly, the US has already hit the US$ 31.4 tn debt ceiling. It did so in January 2023. The US government has been running on 'emergency measures' since then. But this cannot continue beyond this month.

The debt ceiling is a political topic as much as it's an economic one. Discussions are currently on between the two main political parties in the US around fiscal responsibility, government spending, and the level of national debt.

If they can reach a deal before June, the US will avoid a default and government shutdown.

If not...well that's the concern.

Effects of a US government shutdown and/or default

The first thing to understand is that the debt ceiling has always been raised whenever it was reached even during periods of intense political divide.

This is because no politician wants to be blamed for the fallout of a prolonged period of government shutdown or a default. A compromise has been reached, always.

Thus, if a compromise isn't reached this time, no one is sure what will happen. The only thing that we can say for sure is there will be significant damage to the US economy, and by extension, the world economy.

A debt default by the US government would shock the global financial markets to its core. You might have already read the dire predictions about a recession as well as a crash in the stock market, among other things.

The concern is valid. The last time the US was at risk of a default in 2011, stock markets had crashed. But a compromise was found at the last minute.

We could see something happen along similar lines this time as well. But it's not a certainty. There is a small possibility of the failure of negotiations.

In that case, all bets would be off. Predicting what could happen next in a default-like scenario, would be impossible. And it must be said, the discussions haven't made much progress yet, despite the deadline of 1^st June getting closer.

The big fear in the stock market is that of a recession. Even if the US avoids a default at the last minute, there is still a chance that the crisis could tip the US economy into a recession.

This will have a serious negative effect on the rest of the world economy, including a global recession.

So what about the Indian stock market? How will it be impacted?

Impact on Indian stocks

First, if the US defaults, it will cause a crash in the stock market. That's inevitable. The shock would be just too great to ignore. The FII selling would be intense.

What happens after that would depend on how the US government responds. No one can predict that as the US government has never defaulted before and most people believe it won't.

Second, if the crisis ends up like the last one in 2011, there will be a muted reaction. It would be a case of 'been there, done that'. Even if there is a short-term correction, the market will move on once a compromise deal is reached.

But what if a deal is reached but the crisis still causes a recession?

Well, this is a big unknown.

The US economy is not in a very strong situation right now, despite record low levels of unemployment.

The latest US economic data, tells us that consumption is slowing down, wage growth has nearly stalled, manufacturing output is not trending upwards, and high inflation continues to hurt families and corporates alike.

Many economists and CEOs have predicted a recession by the end of the year even without a debt ceiling crisis. This episode will only add to their concerns.

However, in this scenario, it's not clear what would happen in financial markets. It's possible the stock market could go up in the short term if a default/shutdown crisis is averted. But could then turn downwards once the likelihood of a recession becomes clearer.

At this point, it's difficult to say what could happen other than the bulls keeping their enthusiasm in check over the next few days.

It's very difficult to be a short-term trader in such uncertain markets. Uncertainty stops the market from trending in either direction. Traders love trends and are thus, deprived of quick profitable trades.

Long-term investors need not worry about the US debt ceiling. Those who bought stocks back in 2011, did very well for themselves.

As far as long term investing in the most fundamentally strong stocks in India is concerned, we could the a repeat in 2023 as well.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...