|The debt ceiling and the potential effects of this whole process on Wall Street is on the minds of a lot of you. Here are some thoughts.|
At this point, we are not worried. Capital markets, bond spreads and interest rates are not showing concern either. Everyone on Wall Street believes this is grandstanding. Since 1940, the debt ceiling has been raised 80 times.
What is the debt ceiling? The debt ceiling is a cap on how much money the U.S. Federal Government can borrow. The debt comes from past years' deficits. It is a legal limit on borrowing set by Congress and it does NOT determine whether an annual budget will be balanced or run a deficit or surplus. The debt ceiling includes both public debt (money that is owed to investors, foreign governments, pension funds etc.) and intergovernmental holdings (money that is owed to various government programs). The current debt ceiling is set at $14.294 trillion.
We have reached out to several analysts and fund managers from prominent fund families regarding this, and they are not worried either. Everyone believes a last minute deal will be complete.
However, this grandstanding is very unsettling. And no one knows what will actually happen until it happens.
In 1995-1996 a similar event occurred:
- Treasury Secretary urged congress to raise debt ceiling before October 31, 1995.
- By October 17, Treasury announced it would reduce 13 week Treasury bill auction by $7 billion in order to stay under the debt limit.
- Treasury called back $2.4 billion in Treasury cash balances from eight large banks.
- U.S. Congress missed the first deadline to raise the debt ceiling and failed to agree upon a budget to reduce deficit.
- The U.S. government implemented a partial shutdown as a result of the inability to achieve a budget resolution or to meet the debt limit extension bill, suspending nonessential services from early November to early January.
- Treasury Secretary enacted a second deadline of February 15, 1996 to raise the debt ceiling
- Debt Ceiling raised to $5.5 trillion on March 29, 1996.
- Equity markets rallied during the entire debt ceiling impasse of 1995-1996, with slight volatility.
- The 10-yr treasury rallied gradually between the first and second debt ceiling deadlines, however, following Congress's second failure to implement the raising of the debt ceiling, treasuries sold off indicating a loss of confidence in the U.S. government.
What may happen now:
In order to protect the U.S. credit worthiness, the U.S. Government will be forced to make difficult decisions in preparation of the debt ceiling being reached.
- A new budget that includes spending cuts or an implementation of a growth plan to raise revenue will be passed in order to tackle growing U.S. deficit.
- Markets will be volatile during the debt ceiling impasses. For now, it seems markets are expecting the issue to be resolved.
- Missing payments would lead to U.S. defaulting and U.S. credit rating to be downgraded, increasing cost of borrowing. Treasuries will sell off, mortgage rates will rise. Temporary default or downgrade of credit rating would mean higher borrowing costs for the government and U.S. banks both in the near and long term.
- Rating agencies did not play as big of a role in the 1995-1996 debt ceiling impasse as they are playing now and the pressure on Congress to cut back on deficits is increasingly more apparent.
- Some believe that a run on money markets will take place because investors will be fearful of a default.
- Gold may rally as investors seek a flight to quality if the dollar loses its value. Foreign Central Banks may only be allowed to hold AAA assets and if U.S. is downgraded, these banks will be forced to sell U.S. government assets (and may opt to buy gold replacements).
We will continue to monitor the situation.