Update on the Debt Ceiling and Our Thoughts

August 04, 2011

by Nathan Erickson, CFA®, Portfolio Manager

On Tuesday, President Obama signed the much debated Debt Ceiling Agreement, just meeting the August 2nd deadline. At the end of last week, and throughout the weekend, there was significant uncertainty regarding a resolution to the debt ceiling crisis. Debate was focused on the impact of a deal, or the consequences of a lack of an agreement, on markets and the United States' credit rating, with S&P saying there is a 50/50 chance of a downgrade. We would like to share our thoughts on this current event, but first, the details of the deal:

Under the new agreement, the current debt limit of $14.3 trillion will be increased by $2.4 trillion in two stages. The increase will be matched by an equal amount of reductions in projected spending over the next 10 years. The Congressional Budget Office, a nonpartisan agency viewed as an umpire of sorts, estimated that the deal will reduce projected deficits by a minimum of $2.1 trillion in the next 10 years. With the passing of this bill, the Treasury will immediately receive $400 billion in additional borrowing authority, with an extra $500 billion to come later this fall. Additionally, at the end of 2011, a bipartisan committee, composed of 6 Democrats and 6 Republicans, will provide spending reduction or tax increase recommendations that will allow the debt ceiling to be increase by $1.5 trillion. If Congress rejects the committee's recommendations - an up or down vote is required - automatic spending cuts in the domestic budget, including cuts to defense and Medicare, will begin. The hope is that committee members from both parties will be motivated to compromise in order to ensure the programs they most cherish are protected from spending cuts.

While we are relieved that Congress reached an agreement and avoided a technical default of U.S. debt, we made several observations in recent weeks. First, S&P made it clear that they were seeking cuts in the range of $4 trillion or higher in order to avoid a credit downgrade from AAA to AA. Because cuts of this magnitude are unlikely to occur, there is a high probability that we will experience a downgrade in the near future. However, this downgrade is unlikely to have a significant impact on the U.S. Treasury market, similar to Japan's recent downgrade. Additionally, depending on Congress's future budget plans, the AAA rating could be quickly restored.

Many people are wondering why, in the wake of all this uncertainty, Treasury yields have fallen rather than increased. One would assume that the additional risk implied by a possible technical default from not raising the debt ceiling would result in higher interest rates. The United States' ability to maintain low interest rates during this period of uncertainty indicates that U.S. sovereign debt is still the safe haven for investors. Although risk was implied, investors were more concerned about the impact on stock markets, which resulted in many investors moving their money to short-term Treasuries in order avoid the potential volatility in equity markets. This has both positive and negative implications. The good news is that, at the moment, there are no feasible alternatives to the U.S. dollar as the global reserve currency. The bad news is that this sends a message to Congress that our debt and deficit problems are not unacceptable, and the markets will continue to bear increases.

The likely outcome from the debt ceiling experience is that markets will continue to reflect macroeconomic data, which recently has been unfavorable. In terms of sovereign debt, the yield curve will likely steepen as investors move toward shorter maturities and away from longer-maturity debt. Investors will favor this move for two reasons. First, although confidence in U.S. sovereign debt remains high, the longer-term outlook is worsening. Investors seem to be confident in a return of principal over the next five years, but unsure of returns for 10-30 years. Second, long-term debt is more sensitive to changes in yield. If long-term debt is not significantly reduced, volatility in the Treasury market is likely to increase, potentially resulting in unfavorable consequences for investors.

Miller/Russell's investment plan remains the same. We recently allocated a portion of most clients' fixed income portfolio to a global bond fund, to mitigate the sovereign debt risk. This decision was made by our Investment Policy Committee prior to the debt ceiling debate, with the goal of improving the risk profile of our fixed income allocation and to take advantage of better returns in foreign markets. As we continue to monitor the global economy, we will make necessary changes to reflect our long-term investment outlook, and avoid short-term decisions based on speculation. We continue to believe that a well-diversified portfolio will help clients reach their investment objectives.