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Understanding the Debt Ceiling

It is the responsibility of our Treasury Department to meet the government’s financial obligations. As most are aware, our current tax revenue does not cover those debts. In fact, since 1964 the US government has operated at a deficit. To bridge that gap and meet our obligations, the US government is forced to borrow money. It does so by issuing Treasury securities, namely Treasury-Bills, -Bonds and -Notes. In 1917 (during WW1), to curtail overspending, Congress instituted a debt ceiling which limited how much borrowing the Treasury Department could do through the issuance of these Treasury instruments. It is not uncommon for the US to hit that ceiling, which then requires congressional action to raise it or risk not being able to meet financial obligations. In fact, during the decade from 2000-2010 we hit and raised the ceiling ten times!

This required intervention by our Congress has not always been smooth. For example, in early August of 2011 the political maneuverings by Congress almost resulted in US bankruptcy as the Treasury waited for them to raise the debt ceiling so they could issue the Treasuries necessary to pay interest or principal on maturing and outstanding treasuries to avoid going into default on them. It was literally a last minute, midnight compromise that raised the debt ceiling, thereby allowing the Treasury to meet its financial obligations.

Why do we have a debt ceiling?

Unfortunately, between that last week in July and the first week in August 2011, as the looming deadline approached, the Dow Jones Industrial Average lost over 2000 points, and on Monday, Aug 8, 2011 the Dow lost 635 points. It was also during this week that the ratings agency Standard & Poor’s downgraded US debt from AAA to AA+ with a negative outlook. Two other ratings agencies, Moody’s and Fitch, maintained a AAA rating for US Treasuries but did change their outlook to negative. We continue to hold those ratings today.

It falls to Congress to raise the debt ceiling or face defaulting on our debt. And though the U.S. continuously repeats this cycle of hitting and raising the debt ceiling, if US Treasury instruments should go into default, many institutional investors such as mutual funds, insurance companies, trust accounts and pension funds would be legally (fiduciarily) forced to liquidate their holdings in treasury securities. The resulting flood of securities sold into the market would result in a major deterioration of bond prices, and higher interest rates as a result.

Access Free Financial EducationBy most estimates, the result of the US Government defaulting on its obligations would be catastrophic; but as 2011 illustrates, just the potential of this occurring can have a major negative impact on the equity and Forex markets. Despite the risks to our financial systems, this deadline will likely result in congressional grand-standing before the usual last-minute negotiations and compromises result in the debt ceiling being raised… again.

Of course, a solution to all this would be to simply do away with the debt ceiling. Many believe that the annual or even semi-annual exercise of hitting and raising the ceiling only serves to add unwarranted political, economic and market risk to the US economy. Many congressional leaders (of both parties) are now advocating the idea of eliminating the debt ceiling altogether, given that it is an artificial barrier that no longer serves to minimize government spending as was originally envisioned back in 1917. That, however, is a longer-term solution. For the near term, participants in the equity, Forex and derivatives market would be well advised to pay attention to this looming issue.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.