In mid-May the U.S. government reached the statutory limit on the total amount of debt that it can have outstanding. It is, in theory, a very simple matter for Congress to raise the debt limit, but this issue has become linked to a fundamental debate on government spending in general. This debate has led to a political stalemate, with the political left rejecting any changes in spending on social programs, and the political right seeking to curtail federal spending on social programs while rejecting any increases in taxes. The result has been a political standoff, even as the clock has been ticking on the various bookkeeping expedients which will allow the federal government, as a technical matter, to avoid breaching the debt limit until early-to-mid-August. Our clients have had many questions about what this political impasse may mean for investors in U.S. dollar denominated bonds. While developments regarding the debt ceiling and the underlying budget showdown in Congress are very fluid, we want to give our readers a brief analysis of the current situation, what we feel is the most likely outcome, and how we are positioning our clients’ portfolios in light of the situation. Our underlying belief is that negotiations are likely to continue until the last minute, causing uncertainty in the financial markets and possible interest rate volatility, but a deal will ultimately be reached to increase the debt ceiling and avoid even a technical default.
In our opinion, the current debate which attempts to link increases in the debt limit to the far more fundamental debate about what is an appropriate level for federal spending and how it is financed is simply unrealistic: the latter issues are so complex and politically charged that it will literally take years to work them out. We also believe that refusing to raise the debt limit is equally unrealistic. If the United States were to make paying debt service a first priority, this could delay a potential default. However, the resulting cut in spending would lead to confidence-sapping social tumult and monumental problems in the financing of federal government debt. Interest rates would likely skyrocket and credit markets would freeze. A scenario similar to that of 2008 would ensue as banks, corporations, and small businesses would be unable to obtain short-term financing at low-rates, if at all. We won’t even go into the consequences for the value of the U.S. dollar in the international currency markets.
For these reasons, and because all of the political players at the table have publicly stated that they understand the ramifications of a default by the United States on its financial obligations, we believe that there is virtually no risk of default. The difficulty for bond investors is that there is essentially a high stakes game of chicken being played with the debt ceiling. In our opinion the most likely outcome is a compromise which raises the debt limit while establishing a time frame for substantive action to address the underlying spending issues. Unfortunately, no one in Congress has demonstrated willingness to take on the tough choices that are involved in addressing our nation’s long-run structural budget deficit. It is likely that an expected compromise will lack substance, that the bitter underlying financial debate will continue and that we will be dealing with the debt limit issue again in the not too distant future.
SNW Asset Management believes that one of the biggest risks is thoughtless comments by politicians which have and will continue to alarm investors, particularly foreign investors who now own approximately 50% of outstanding U.S. Treasuries. We continue to position our client’s portfolios conservatively, giving us the flexibility to take advantage of any short term volatility. This includes focusing on short to intermediate maturities and on bonds with strong or improving credit quality. Should volatility increase and interest rates rise dramatically, we expect to take full advantage of the opportunity by reinvesting in sound securities that are severely affected by the turmoil.