The Debt Ceiling Debate: Worst-Case Scenario

A downgrade won't be shrugged off so easily this time around

By Daniel Putnam, InvestorPlace Contributor

Just when you thought it was safe to invest without having to worry about the next headline out of Washington, we face an issue that could have a much larger impact than the fiscal cliff:

The country’s debt limit.

This issue has much broader implications for the Treasury market, meaning that the lesson of the fiscal cliff — i.e., that debates regarding fiscal issues are mostly media hype — doesn’t apply here.

A Brief Review of the Debt Ceiling

In a nutshell, the debt ceiling is the maximum amount that the U.S. Treasury is allowed to borrow based on the limit set by Congress. Currently, the limit is $16.4 trillion, which the country hit on the last day of 2012. As of Wednesday, in fact, the U.S. debt load stood at exactly $16,432,705,914,255.48, according to the TreasuryDirect website.

This isn’t necessarily a problem just yet, since the Treasury can employ stop-gap measures to continue meeting its obligations for another six to eight weeks. At that point, however, the United States will no longer be able to borrow — which also means it won’t be able to pay its bills … or the interest on its bonds. This problem can be avoided if Congress votes to raise the debt ceiling, but this isn’t as easy as it sounds, as Republican lawmakers will demand spending cuts in exchange for their votes. This same partisan wrangling is what brought about the first debt ceiling crisis — and the attendant market volatility — in August 2011.

Could the United States Actually Default?

In theory, yes.

If Republicans and Democrats can’t come to an agreement by the time the Treasury exhausts all of its measures, the country would indeed default. The odds still are against this occurring, because it is extremely unlikely that lawmakers would allow such a financial catastrophe to occur.

However, the odds also are at least greater than zero. Chris Krueger, a senior political analyst at Guggenheim Partners, wrote the following earlier in the week:

“The next fiscal cliff is going to be more toxic and could end with an almost unthinkable conclusion: a technical default on the U.S. debt. We are raising our odds of a debt default from 10% to 20%. This is largely due to the brinksmanship and regained leverage that Republicans will have on the second fiscal cliff.”

Even Without a Default, the Market Impact Could Be Substantial

If this doesn’t have you concerned, another issue should: the potential for additional downgrades of the United States’ AAA credit rating — an event that could occur even without a default.

Recall that in August 2011, Congress came to an agreement on the debt ceiling at the eleventh hour, but Standard & Poor’s stilled stripped the country of its AAA rating due its growing debt and the gridlocked political climate in Washington. This didn’t have a significant market impact at the time, since Fitch and Moody’s (NYSE:MCO) both maintained their AAA ratings.

Two years later, of course, both the debt and gridlock problems have gotten worse, which means that dragged-out negotiations and further rancor could prompt Fitch and Moody’s — both of which have a negative outlook on the United States’ creditworthiness — to issue similar downgrades.

If such an event occurs, don’t expect Treasury yields to fall (and prices to rise) as they did following the S&P downgrade in 2011. This time around, additional downgrades will have a much different impact because the United States will no longer carry a AAA rating. This would be a monumental event for the markets, since countless investors — such as banks, pension funds, certain mutual funds, etc. — are compelled, by mandate, to hold only AAA-rated securities.

Once the AAA rating goes away, these entities will need to sell their investments in Treasuries.

The result of additional downgrades is therefore likely to be a substantial selloff in the Treasury market, which would send shockwaves through the credit markets and lead to significant short-term downside in equities. It’s true that on a longer-term basis, this event could spark the long-awaited reallocation from bonds into equities, setting up a stealth bull market in the second half of the year. For now, however, the debt ceiling debate is the most important issue for the markets — and it has much broader implications than the media-fueled fiscal cliff ever did.

Already, Treasuries are beginning to feel the heat: After trading as low as 1.59% as recently as early December, the yield on the 10-year note has spiked to 1.94% as of midday Friday as its price has fallen. During this time, the flagship long-term Treasury ETF — the iShares Barclays 20+ Year Treasury Bond Fund (NYSE:TLT) — has shed 6.3%, wiping out more than two years’ worth of its 2.7% yield.

The Bottom Line

The rest of the financial markets seem to be taking a sanguine view of the debt ceiling issue on the assumption that it will get ironed out at some point, but this fails to take full account of the possibility that U.S. government debt will suffer additional downgrades in the months ahead.

As long as the debt ceiling remains unresolved, investors would be wise to factor this issue into their thinking.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

The opinions contained in this column are solely those of the writer.

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