The U.S. government has spent itself into a multi-trillion abyss and the reckoning day is nigh. Does the government raise its debt ceiling and try spending itself out of debt? Or does is it scale back and stop deficit spending? With an August 2nd decision deadline looming, how should the U.S. government’s fiscal problems affect the way you invest?

Let’s look at this topic from an investment angle, minus the political hype.

Debt Ceiling 101

The government’s debt ceiling is comparable to the maximum spending limit on a credit card. Once the cardholder’s line of credit (or debt ceiling) has been reached, they’ve maxed out their borrowing capacity and the only way they can increase their borrowing limit is to get approval from the credit card issuer.

For another explanation of this same concept, here’s what the Treasury Department says:

“The debt limit is the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments. The debt limit does not authorize new spending commitments. It simply allows the government to finance existing legal obligations that Congresses and presidents of both parties have made in the past.”

Currently, the government’s debt ceiling is $14.29 trillion – a figure that was reached in May. Richard Fisher, the Dallas Fed President called it a “fiscal sinkhole.”

Borrowing Limits vs. Borrowing Cost

The deteriorating financial condition of a borrower coupled with a maxed out credit line typically leads to higher loan rates. This is a common occurrence with financially over-extend consumers just as it is with corporations in the same predicament. Why? Because distressed borrowers inevitably get borrowing rates reflective of that distress. Oddly, this hasn’t been the government’s case.

The yield on 10-year Treasury notes is around 2.95%, well below the 7% average over the past three decades. The yield on three-year Treasuries is just 0.65% and five-year inflation linked securities yield around 0.44%. Similar yield trends can be seen in U.S. Treasuries with 10-20 year durations and 20+ year durations. Do any of these numbers reflect distressed borrowing rates? Obviously not.

In contrast to foreign governments like Japan, the majority of U.S. government debt is not domestically held but foreign owned. What does it mean? The translation is that the government is immensely dependent on the lending generosity of strangers. And thus far, these strangers have been delighted to continue lending capital to the government at absurdly low rates. Are you one of them? If yes, your investing peculiarities will bite you when you least expect. If no, there’s still time to join the bandwagon, so hop on!

Warnings Galore!

Concerning the government’s fiscal quagmire, everyone is warning each other. The Fed has warned Congress about the need to raise the debt limit, economists have warned the Fed about the danger of more quantitative easing and hapless credit raters have warned the U.S. government about the potential for credit downgrades. Is anybody listening to each other? Probably not.

What would occur if the government failed to increase the debt limit by August 2nd?

“It would cause the government to default on its legal obligations – an unprecedented event in American history,” says the U.S. Treasury Department. “That would precipitate another financial crisis and threaten the jobs and savings of everyday Americans – putting the United States right back in a deep economic hole, just as the country is recovering from the recent recession.” Come to think of it, doesn’t that warning resemble the warnings given just before Wall Street won its bailout lottery?

The Next Move

Instead of celebrating the U.S. government’s low borrowing costs, it raises red flags. When it comes to deficit spending, the credit market is often complacent about risk. But the fickle nature of these very markets can quickly turn at any given moment and Europe’s crisis provides enough evidence.

“When markets lose confidence in the U.S. and say they don’t trust us any more, rates will skyrocket and the crisis will be upon you,” stated James Bullard, president of the Federal Reserve Bank of St. Louis.

In summary, the U.S. government’s dubious fiscal situation presents a whole slew of unfamiliar problems. And preparing your investment strategy for these pitfalls ahead of the storm is the wise course.

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