“What’s Going To Happen August 2”

© 2011 Mel Collins

First, you’ve been exposed to two separate issues as if they were one… The debt ceiling… and the budget deficit. There are only a few things that can happen, so let’s separate the issues and look at the potential effects… one at a time. Let’s first look at “Default”. Default is defined as not paying debts owed. Those debts are the interest payments on bonds and the return of principal on bonds that mature.

The Treasury has about $83 billion in its pocket right now… and on the average receives about $200 billion monthly. Debt service for August will be $120 billion including interest and principal. So, there should be enough money to cover debts owed for August.

If, for any reason, the Treasury defaults, or in essence, misses the deadline for payment of debt, it will make it less appealing for a bond buyer to buy US Government bonds… unless, of course, interest rates go up.

If Treasury rates go up, all interest rates will go up, making it more expensive to borrow money… not just for the government and the debt it sells, but for everyone the government lends to… like the banks.

Of course, if the banks have to pay more interest, they’ll have to charge more interest… that means the end user, the person who has a mortgage, a car loan, a student loan, a credit card carrying a balance, etc. will be facing higher interest rates as well.

On the business side of the equation, whether a mom & pop retailer or a Fortune 500 Corporation, businesses will be paying higher interest rates too.
When the cost of borrowing goes up, wholesale and retail price increases follow like day follows night.

You can see the Treasury is likely to avoid default and do whatever has to be done to make the necessary payments.

Additionally, the Treasury has obligations to pay government employees, suppliers and other commitments.  If the debt ceiling is not raised the government will not be able to pay everyone. When you or I are in such a situation, we create priorities… and that’s just what the Treasury will have to do if the debt ceiling is not raised.

That could force the Treasury to turn other assets into cash. What other assets? Our buddies at the Treasury own about $95 billion in mortgage backed securities… and they can be sold… and if debt payments are covered and the mortgage backed securities are used to cover the other commitments, the Treasury will meet its debt and its obligations.

If there’s no default but a budget is not developed to meet long term debt and obligations, it is likely that the credit rating agencies will reclassify US debt from AAA to the “AA range”.

At worst that’s the rating Standard & Poors said it would rate US Government debt. That’s a downgrade of one to three steps… and that will happen if $4 trillion in budget savings over the next ten years is not agreed upon.

In mid July Moodys said it would downgrade to the “Aa range” if the debt ceiling is not raised in a “timely manner”. That’s also within the 1-3 steps down range. None of the rating agencies indicated they would downgrade any further than that.

Where does that leave current and future debt obligations?

Well, because of the characteristics of US debt, especially when compared to alternatives, I believe most investors will continue to hold U.S. debt.

According to Zane Brown of Lord Abbot, a leading investment house specializing in bonds, “U.S. households, corporations, state and local governments, banks, and pension funds held about $3.14 trillion in Treasury holdings as of late July. In addition, the single largest holder of U. S. Treasuries, the U. S. Federal Reserve, has about $1.3 trillion in treasury holdings following its various quantitative easing initiatives. Few of these investors are likely to sell their Treasury holdings even if the credit rating were downgraded. Foreign central banks and foreign wealth funds, however, may look to diversify their $3.16 trillion in Treasury holdings. While this has been an ongoing trend, the uncertainty over the budget situation has likely reinforced the decision for some of these investors, who may diversify into other ‘AAA’ rated fixed-income assets, such as those issued by Canada or Germany. This continued diversification could push Treasury yields slightly higher and affect the value of the U.S. dollar in the foreign exchange market. Collectively, a downgrade of U.S. debt may not have a significant impact on Treasury rates since ‘AA’ bonds generally trade about 25–30 basis points wider than ‘AAA’ bonds with similar maturities. The potential increase in yields is most likely to occur on long-term Treasury securities as investors react to the inability of Washington to address long-term spending issues. This would result in a steepening of the yield curve”

Here’s a simple way to understand what a downgrade of U. S. debt would do to the bond market.

Bonds carrying a rating the same as those of U. S. debt would not be appealing to bond investors if they didn’t pay at least what U. S. debt was paying. They would, then, go down as well… to allow for the yields to match those of U. S. debt. Taking it a step further, there are investment houses that, by their own rules, carry predetermined liability levels.

In essence, they blend higher rated debt with lower rated debt to achieve a structured overall yield with certain predetermined risk levels. Bonds issued by companies doing business with the U. S. government would most likely go down because government spending is reduced. If government spending is reduced, those supplying the government will most likely experience less business. Less business means less income… means less profits… means a lower ability to pay debt.

Here’s the bottom line… U. S. government debt will continue… whatever happens on August 2. The bond markets will adjust to be competitive with U. S. debt and bond prices will go down since yield will go up. Interest rates in general will go up. This will cause a slow down in the economy. When mortgage rates go up, housing prices decline… when the cost of business goes up, products and services become more expensive and sales decline. When sales decline, employment declines. Things are not getting better, they’re getting worse. What’s an investor to do? Stay tuned…