Video Update: Is the Debt Ceiling Crisis Over?

With a debt ceiling deal on the horizon, investors are starting to wonder: Are we out of the woods of uncertainty?

In today’s video update, Chief Analyst Adam Galas goes over all the moving pieces involved in this deal, the key government players, and what’s most important to look out for.

Based on the impact this will likely have on the economy, he’ll tell you about one investment – which we hold in our Fortress Portfolio – that could rise double digits.

Click below to watch the video or read the transcript.

Happy SWAN (sleep well at night) investing,

Brad Thomas Editor, Fortress Portfolio

Welcome Fortress Portfolio members to another weekly video update.

Today we’re talking about the debt ceiling crisis and how it’s over… Maybe.

For the last three weeks, we’ve been exploring the dangers of the debt ceiling to the U.S. economy and the stock market.

We’ve gone through the history of the debt ceiling, including the more than 100 times that it’s been raised since being created in 1917.

As you can see, this is not a partisan issue.

56 times Republican presidents have raised it and 44 times Democratic presidents have.

Now, the good news is that House Speaker McCarthy and the White House did reach a deal over the weekend to avert a debt default at the last minute, just like S&P and Goldman have been expecting all year.

We now have till June 5th according to the Treasury’s best estimate. That’s just under six days.

Now, let’s talk about what’s actually in this deal and what’s going to happen next as we try to avert the debt ceiling doomsday.

The firings of both parties, the progressives and the Freedom Caucus are quite livid with this deal. And here’s why.

First, let’s consider the House bill Limit, Save, Grow Act that was passed two weeks ago.

Now, this was designed to cut $4.8 trillion off the deficit, which the Congressional Budget Office estimates will be about $20 trillion over the next decade.

For context, Congressional Budget Office estimates that in order to avoid a debt doomsday spiral over the coming decades, we need to cut that deficit in half to $10 trillion.

So basically, this gets us around halfway there.

Now, this act would have set 2024 spending levels at those seen in 2022, effectively around an 8% cut while raising defense, spending about 11% and cutting non-discretionary non-defense social programs around 17%. It also would have capped future spending for the next decade at 1% growth rates, which, of course is below the rate of inflation. And would have eliminated $400 billion in student loan forgiveness and reversed much of the Inflation Reduction Act, specifically the green energy tax credits.

It would have eliminated $80 billion or $8 billion per year from additional IRS spending, which is part of the IRA, and designed to hire 87,000 new agents to try to close the fund.

Basically, the tax gap, which is estimated to be about $600 billion per year or $6 trillion for the next decade.

It’s estimated that this extra 80 billion would have collected $220 billion in additional tax revenue.

Now, it’s important to point out that this is money that is legally owed basically every year, $600 billion in taxes that is legally owed after all the deductions, but is not collected due to tax evasion.

In addition, work requirements were added in the House bill for Medicaid and food stamps, which I estimate would have saved $120 billion over ten years.

Finally, the reductions in regulatory requirements for energy products, both fossil fuel and renewables, were part of the original plan.

Now, on the Democratic side, progressives were calling work requirements their red line in the sand. And the fact that those are still included is why they are so upset. In fact, for weeks, dozens of progressives and Democratic senators have been calling on Biden to invoke the 14th Amendment, which says that the validity of the U.S. debt cannot be questioned.

In other words, the argument is that the debt ceiling is unconstitutional and Biden should just order the Treasury to keep selling bonds and just ignore it.

While that’s likely true, it’s something that Fitch warned us we should not try.

In fact, Fitch came out last week and warned that if we invoke the 14th Amendment, then the U.S. would be downgraded from AAA to AA+, which you might not think would make a big difference, but it does.

But according to JPMorgan (JPM), it likely would have increased U.S. borrowing costs by 0.5% forever, resulting in $1.7 trillion in extra borrowing costs and larger deficits in the next decade.

So what is this actual deal that that the White House and McCarthy struck? That 200 House members are so upset over?

They say they might not vote for it. But, the debt ceiling is suspended to February of 2025 after the next election.

Notice it’s not raised. It’s simply suspended, allowing the Treasury to borrow as much as they need up to that time.

Now, spending is basically staying flat at 2023 levels, so slightly negative when adjusted for inflation.

But basically, what the Biden administration was offering. Note that the actual spending begins on October 1st, the start of the next fiscal year.

Now, the ten-year spending cap is now two years with the 1% increase, only applying to 2025. The work requirements will be phased in over several years and are currently set to sunset in 2030.

With veterans and disabled Americans excluded from the new requirements, the Pentagon spending, which a GOP bill had as an 11% increase, is now a 3.3% increase.

And social programs spending cuts are not 17%, but about 7%.

Now, the deregulations on energy projects are not as strong as the GOP would have liked. But Joe Manchin, interestingly enough, was able to get the Mountain Valley pipeline in his home state. It was 96% completed but tied up for years in courts. Now it is finally added to the bill.

So that $80 billion in new IRS spending has been cut by $10 billion, down to $70 billion.

Now, what about the economic impact?

Well, Moody’s estimates that this a far more moderate bill. The compromise that’s been struck should have around a negative 0.1% GDP headwind for 2024. Bloomberg Economics estimates slightly higher at about 0.5%.

Now, in terms of deficit reduction, of course (which is the entire purpose of this exercise), that is estimated to be down to $2.3 trillion.

Basically, we are at half of the House’s original proposal and about 25% of the way to where the Congressional Budget Office (CBO) estimates we need to be in order to achieve sustainable debt levels long term.

Now, of course, that small reduction is disappointing to me as well as most deficit hawks, but this is not actually surprising because remember that the debate over the last two weeks has been basically over 13% of the budget.

Defense, Social Security, Medicare, veterans’ benefits. All of this was off the table.

So naturally, you cannot expect to get that strong of an effect.

So given the limitations on what we were debating on, it’s actually a pretty good down payment on deficit reduction.

You can’t solve a $10 trillion problem when you’re only looking at 13% of the budget.

So what happens next? Well, the deal was struck on Saturday night, and McCarthy said that by Wednesday he wanted to have the final draft of the bill ready, which is 90+ pages long.

So that three-day countdown for the House actually reading the bill and voting on it can now begin.

Now, note that Bloomberg estimated that it would take two days to actually write this legislation.

So the fact that they did it in half the time, that’s quite impressive.

Yesterday, May 30th, the House Rules Committee, which consists of nine Republicans and four Democrats, voted 7-6 to advance the debt ceiling bill to the floor.

Now it goes on to the next stage.

So far, 100 GOP and Democratic congressmen and women have said they are considering voting against the bill for various reasons. That leaves 235 undecideds. And we need 218 votes needed to pass.

Senate Majority Leader Schumer says the Senate will wait until the House bill passes before it tries to pass its own version because they want to do something called unanimous consent.

Basically, if the House passes the bill, the Senate, if they have the votes, can with just a voice vote (without any kind of prolonged process), can pass it by Friday. Then the president can sign it and, boom, crisis averted.

Now, things could still go wrong.

So let’s talk about that, because as I said, this crisis is not necessarily over.

So first, some members of the Freedom Caucus are understandably very upset at McCarthy for what they view as capitulation.

As a result, they’re threatening to try to remove him as speaker.

Now, this is called a motion to vacate. And why this matters is that when McCarthy was running for speaker in January and it took 15 ballots for him to get it, he had to cut a deal that allowed any member of the House, Democrat or Republican, to call for a motion to vacate to basically remove him as speaker.

If it does require an overall majority in the House or 218 votes, and 200 congresspeople are saying they might not vote for the bill, it’s very unlikely that he would actually be removed.

If he was, that would add to the crisis. You see, without a speaker. A bill cannot be brought to the floor other than with a discharge petition.

But as we talked about last week, that takes nine days. We have less than six.

So if he was removed as speaker, in the last days of the debt ceiling countdown, the House would not be debating the debt ceiling at all.

And who would be replace McCarthy as speaker?

The alternatives to McCarthy in those 15 ballots, the runner up got only five votes.

So basically, there is no person to replace him if he were removed.

Now, of course, the good news is that is highly unlikely. The problem is that Moody’s estimates roughly a 50% chance that this vote will actually pass in the House based on what we’ve been hearing so far.

When the Troubled Asset Relief Program (TARP) bailout failed on September 29, 2008, the market was not happy. The Dow fell 7% and the stock market, fell even more at 9%.

And mind you, nothing was spared on that dark day. Johnson & Johnson (JNJ) fell nearly 4%. Utilities fell over 5%. The only thing that went up were long bonds up about 5%.

If the House vote were to fail, then stocks would likely crash.

Moody’s thinks there would be a 2000-point decline in the Dow, about 6%.

And the good news is, of course, this would scare rich people who then called their lobbyists, who didn’t call Congress and yell at them to do their jobs and get this thing passed.

Now, this means basically the second vote would be on Thursday.

But, if that were to fail, then likely stocks would react even more violently, something along the lines of March 16th, 2020, the third worst day for stocks in U.S. history.

That was a very bad day. Stocks down 12%. Even Johnson & Johnson, AAA rated and arguably the safest dividend stock in the world, was down 5%.

Utilities were down 10%. Bonds up 6%.

Now, in terms of the Senate, things get complicated because remember, as we talked about last week, the Democrats have 51 votes.

They need nine Republicans to break the filibuster. The breaking of the filibuster just means cloture, essentially ending debate and actually voting on the floor.

Any individual senator can potentially start a filibuster.

For example, if you’ve seen the movie, Mr. Smith Goes to Washington, it shows that a person can stand there and keep talking for as long as they want.

Now, theoretically, senators can work together in a team and prolong this process by up to a week. Again, we have less than six days. So if someone wants to force a default, there’s pretty much nothing we can do to stop that.

But, there is some good news about the potential for the default if it were to happen.

Remember, Secretary Yellen says June 5 is the new default date now based on some accounting maneuvers.

She said that yesterday, May 30, she would sell $170 billion in Treasury bills (T-bills).

Now, the reason this is important is that it gets us over the hump of June 1 and 2, in which there are $141 billion in estimated payments, mostly Medicare and Social Security.

But there’s a deficit of about $110 billion on those two days, meaning that if we weren’t able to raise the debt ceiling and she sell $170 in T-bills, then we would default on June 1 and 2.

And as Moody’s explains the June default scenario that could cause a recession, all of that damage would essentially come from these two days.

So even if, in some worst-case scenario, we aren’t able to raise the debt ceiling this weekend, the defaults would be relatively minor. The revenue and payments are roughly due on June 9 and June 15, for a total of around $80 billion in corporate taxes.

Basically, there is $143 billion in additional emergency measures having to do with government pension accounts that become available to get us to the end of July.

So what about your Fortress Portfolio? Remember, Fortress is 33% hedges, 17% zeros (bonds that pay no coupon or interest payment). PIMCO 25+ Year U.S. Treasury Index Exchange-Traded Fund (ZROZ) is the longest duration Treasury ETF you can buy.

And right now, bonds are having a very good day as of yesterday when I made this video, they were rallying around 2%, four zeros.

Now, why is that? We’ll talk about that next week.

But here is basically the takeaway.

Depending on when this recession begins, in five weeks or five months, and how severe it is, 30 year yields are likely to fall from around 4% to between 1.75% and 3.5%.

That’s a potential 65% gain in bonds.

And even if that doesn’t happen, the good news is that the Fed is almost done hiking.

So what happens to bonds historically when the Fed stops hiking?

Well, over the first two years, bonds do very well indeed. T-bills can be up 13%. Investment grade bonds, which have a duration of seven years, up 27%.

And remember, zeros have a duration of 27 years, basically four times as long. They historically double in the two years after the Fed stops hiking rates.

Not bad.

As I close today, please remember to send us your questions and feedback so I can respond to them in these videos and our monthly issues.

Just remember, I can’t provide personalized investment advice.

Thank you for joining us this week and I hope you join us next week for part five of our debt ceiling mini-series.

We will look at how the end of the debt ceiling crisis creates a $2.2 trillion headwind for stocks.

Yes, the end of the crisis might actually be what triggers the final leg lower in this bear market… Which of course is going to bring with it incredible and potentially life changing opportunities that you won’t want to miss.

And thanks to Fortress, you won’t.

Until then, this is Adam Galas, wishing you and your family safe investing, and a healthy and joyous week.