Debt Ceiling Debate Stirs Concerns for Treasuries
Posted by Barry Simson on July 20, 2011
The 800 pound gorilla in the room is the debt ceiling negotiation. As seems to be human nature, we are down to the last few days before trying to get some serious solutions in place. For each dollar the government spends, it has to borrow more than 40 cents. Certainly that is an unsustainable situation. Yet safeguards are not in place to keep from accumulating a dangerous amount of debt.
Without trying to project what is going to happen, let me touch on some possible implications to the debt talks:
- The debt limit is not raised and some form of technical default occurs, i.e. some payments are late. This would cause our interest rates to rise if even just for a short time. If our ratings were not restored quickly, rates could stay high for a while. If debt limits are not imposed with a reduction in debt over time, rates could be significantly higher. At least three of the PIIGS countries (Portugal, Ireland, Italy, Greece and Spain) have rates over 10%. Higher rates would have negative implications for the economy and the cost of future debt. Additional actions could occur. The dollar could plunge in value versus other currencies causing imports (like oil) to rise significantly in cost. China could decide to dump its Treasury bond holdings causing rates to rise further. A default, even for a short time, would cause reactions that at this point we can not predict, the law of unintended consequences.
- The debt ceiling is increased without significant reductions in debt. There will be a sigh of relief to be past the deadline but rates will still be subject to increases once the markets turn their sights on the U.S. debt levels. This means we will need to sit through additional rounds of negotiations as the politicians wrangle with raising revenue versus cutting spending.
- The debt ceiling is increased with significant reductions in future debt levels. This one piece of uncertainty is resolved and that would help with stability. Rates could decline further both due to future debt level and the removal of uncertainty.
Time will tell how this plays out.
In the meantime, it appears the Fed is mostly on hold at the moment. Last year, QE2 (Quantitative Easing 2) was talked about starting in August. Stocks, commodities and inflation all rose after that. With the economy still sputtering along, a number of Fed governors have said it is not the Fed’s place to create strong growth. That should be the result of fiscal (taxes and spending) and regulatory policies. Still, the Fed is continuing to keep interest rates at exceptionally low levels. Economists have predicted the first rate increases to come during the second half of 2012 or the first half of 2013. At least one investment banking firm has said it is possible (although it is not their prediction) that rates will stay at these levels for another six years!
It’s no doubt that Treasury yields will, in the near term, be influenced by the political maneuvering that accompanies the debt ceiling, tax rates, and spending debates. While Treasury prices may continue to be volatile they can still hold a valuable position in one’s portfolio. You may ask, “But what if they default?” Keep in mind that the image of a default and the reality of one can be vastly different. For instance, the statement that a bond has “defaulted” often conjures images of a security losing 100 percent of its value or the issuer being bankrupt. In actuality a bond can be in “default” even if it makes just one interest payment a day late. If the U.S. Treasury were to default, and that is an “if” of historic proportions, it would most likely be a late interest payment. We do not believe that the United States would default on any principal. In fact, not making payments may be unconstitutional. After some debate, elected officials would be required to make concessions that would fund any Treasury short-fall and payments would soon return to the appropriate schedule.
Concerns about holding U.S. Treasuries should not be analyzed in a vacuum. In building an investment portfolio, we compare the risks of each asset class with the relative risks of the other asset types. The headlines and news about the possibility of a Treasury defaults has led many to seek other places for short-term investments that have guarantee of principal. It is important to keep in mind that the guarantees of other domestic investments are in most cases ultimately backed by the U. S. Government. The FDIC is partially funded by the interest it earns from its investments in, you guessed it, U.S. Treasuries. Insurance companies are backed by the “claims paying ability of the issuer”. Yet as we have seen recently, when the issuer becomes insolvent then the government may step in to back the company. Witness AIG, Phoenix, and The Hartford. Given that the Euro is also facing pressure, it is not a sure bet that Treasury rates would spike (though they might) on a U.S. default since the dollar is currently the only reserve currency in the world. Where should money go in a flight to quality if it were fleeing any perceived risk in U.S. Government debt? There does not seem to be any viable alternatives that have less investment risk. And since Treasuries represent the largest and most liquid market on the globe, we would probably still choose to hold a position.
The conclusion then is that Treasuries are still “safer” as an investment if one is considering the safety of their principal. We therefore expect to continue to have an allocation to Treasuries for portfolios where liquidity and/or safety of principal are an objective.