Debt Tango

Posted on August 1, 2011 by David Laidlaw

Over the past few weeks, the country has focused on whether or not our dysfunctional government will be able to reach an agreement before hitting the “Debt Ceiling” on August 2nd to avoid defaulting on our obligations. John Boehner, the Speaker of the House, Harry Reid, the Senate Majority Leader, and President Obama have embraced, separated and maneuvered across the political dance-floor without achieving any concrete agreement to lift the uncertainty that hangs over the markets. 

Some of the political and media rhetoric is misleading.  Even if there is no movement to increase the debt ceiling by August 2nd, it is highly unlikely that the government will “default” on its bonds.  There is plenty of money flowing into the US Treasury to pay the interest on the bonds and to repay principal on Treasury Bills and Notes as they mature.  There may be enough money to pay the military, Social Security and Medicare.  However, without an increase in the debt ceiling, there will not be enough cash flow to cover anything else. 
 
Regardless of these frightening prospects, the markets are still relatively calm.  The yield on the 10-Treasury Note is now an amazingly low 2.78%, which suggests that bond-buyers are not expecting any default.  Similarly, the S&P 500 has only decreased by 1.4% so far this month and is still up over 4% for the year. 
 
Our expectation is still that a last minute deal will be brokered within the next week or two to avert a crisis.  Such a deal will most likely be more short-term in nature given that both Republicans and Democrats will be able to use the debt issue to demonize their opponents in the coming 2012 election.   If this scenario comes to pass, the markets will probably stabilize, but there will be insufficient confidence to enter another bull market.  

The only silver-lining to these circumstances is that we are finally beginning to confront the immense fiscal challenges that have been building for decades.  The government cannot indefinitely spend roughly $100 billion more than it receives in tax revenues each month.  If a long-term solution is ever achieved, the equity markets will rally strongly from these levels.