Forget the government nonsense about the U.S. debt ceiling “deal.” All the posturing, scolding and cajoling ignored an important point.
The fact is, even with the President’s and Congress’ agreement to increase the government’s borrowing limit, America is still in deep financial trouble. And this reality will affect investors much more than they expect.
Before I explain why, let’s get beyond the rhetoric and see what’s really going on.
First of all, raising the debt ceiling is not a magic cure-all for America’s debt problems. Raising the ceiling just gives the U.S. Treasury permission to borrow more money. It does that by issuing Treasury bonds and notes — in effect, they take out loans, promising to repay the bondholder the principle plus interest.
Here’s the thing, though — right now, the only way the government can repay its existing debt obligations is to take on more debt!
According to the Bipartisan Policy Center, almost $500 billion in U.S. Treasuries will mature in August 2011. Mature, as in, the government will need to make good on the loans. If it’s short by a single dollar, the United States is in default.
Keep in mind, that’s $500 billion on top of August’s projected $159 billion budget deficit. So the government will need to raise $659 billion, just to keep the lights on during the month of August alone!
To put that in perspective, that’s more debt than the entire QE2 debt-buying campaign… in one month… without the Feds as the backdrop to buy the debt.
So if the debt ceiling is raised, one of the top priorities will be to “roll over” its existing debt — that is, create new debt to pay off old debt. It’s sort of like using credit cards to pay your mortgage.
And that’s still not the end of it. According to the U.S. Government Accountability Office, just over $3 trillion of debt matures during the next four years. Yet the debt ceiling plan coming out of Washington aims to trim the budget by just two trillion dollars over the next 10 years.
Essentially, no matter what the House, the Senate and the President agreed on, the United States will need to continue borrowing money to pay for the money they’ve already borrowed.
To roll over so much debt, the United States will need a lot of investors willing to step in and buy that debt. But as more investors worry about America’s financial health, they will need more incentive to buy its notes and bonds. Convincing them to take on the risk will require a higher interest rate.
You can see that happening in Europe right now. Despite all the problems in the eurozone, the German economy remains fairly strong. Since it’s in such a low-risk position, the yield on a short-term German bond is less than 2%. But in Greece, where a government default seems inevitable, bonds are yielding over 14%. And Greece’s 2-year bonds yield more than 30%!
That’s one of the reasons there’s so much worry about the United States’ credit rating. A lower rating means the United States would have to pay higher rates to borrow. As long as the government can keep rolling over debt, the United States will certainly keep its AAA rating. Raising the debt ceiling eliminates the risk of an immediate downgrade… but it won’t eliminate the risk of a downgrade in the future.
The Bipartisan Policy Center spells it out: “Treasury will have to pay higher interest rates to attract new buyers… [or] it is possible, if unlikely, that not enough bidders would appear.”
As you no doubt noticed, the Bipartisan Policy Center thinks a failed Treasury auction is unlikely. It has a good reason to believe that, too. So far, people have had no trouble buying U.S. debt.
You’ve no doubt heard the stories — the Treasury Department reports that China holds $1.2 trillion in notes and bonds. Japan is sitting on $912 billion. Conspiracy theories aside, there’s only one reason these countries are holding U.S. debt — because they think it will pay off. But the debt-ceiling debate is probably creating some anxiety among the biggest traditional buyers of Treasury debt.
As Howard Marks of Oaktree Capital warns, “The world has awakened to the undesirability of ever-growing government debt.”
OK, so far this discussion has been fairly abstract. The amounts of money involved just boggle the mind, and the politicians have spent more time talking about “our children’s future” or “not mailing Social Security checks” than the day-to-day consequences for you.
Unfortunately, that’s exactly why so many investors are going to get blind-sided.
Higher Treasury rates will create a ripple effect, forcing other interest rates up, too. Suddenly, the cost of borrowing money goes higher for everyone, which will encourage more saving than spending.
Say goodbye to the recovery!
Then there’s the U.S. dollar to consider. A massive bond sell-off will put it in the tank. As Marks puts it in this situation, “I strongly doubt the dollar can remain the world’s reserve currency.”
Gold, oil and anything else denominated in U.S. dollars will soar.
Pretty scary stuff. And remember, this can all happen even with an agreement on the debt ceiling. Things are out of the government’s hands. We are completely at the mercy of the people holding America’s debts. If they stop borrowing, we’re sunk.
To be clear, this isn’t the fault of any political party — for decades we’ve rung up more and more debt regardless of who was in power. And this isn’t some crackpot scheme by other countries to bring America down — a U.S. default or ratings downgrade would be just as disastrous to them as it would be for us. In fact, we’ll need their support to keep us afloat!
Understanding what’s happening is the first step to protecting yourself. Stay away from the U.S. dollar as much as you can. Consider ways to invest in gold and oil, whether physically or in the form of exchange-traded funds.
For Markets and Money Australia