US Debt Limit

This week the top story was the USA reaching its debt limit of about $14.3 Trillion and the fear of default. While lots of experts have already provided insight on this topic, I want to provide input on the impact for holders of US Treasury Bonds. The first section is from Vanguard. The last section is some trivia for your enjoyment.

Vanguard

While recent reports provided reasons to pause and ponder the condition of the U.S. economy, the gradual recovery doesn't seem to be in danger. Somewhat negative news came from the index of leading economic indicators, existing-home sales, and new residential construction. While economists expected better from all three, there were explanations rather than alarms. The Federal Reserve Board's release of meeting minutes indicated that care must be taken when it eventually weans the economy off its support. For the week ended May 20, the S&P 500 Index fell 0.3% to 1,333 (for a year-to-date total return—including price change plus dividends—of about 6.8%). The yield of the 10-year U.S. Treasury note fell 3 basis points to 3.15% (for a year-to-date decrease of 15 basis points).

US Debt Limit and US Treasury Bonds

If you an investor, this is the main event for the year. The best way to watch this unfold is to watch the US Treasury yield curve that shows the interest rate for all debt issued by the US Treasury. If you are an investor that has purchased these bonds and plan to hold onto these bonds until maturity this has less of an impact than someone who is now purchasing these bonds. The foundation for all investing strategies is that all US Treasury debt has no risk of default so that this is a really, really, really big deal.

Since this is the main event, let's introduce the players like a boxing match. In this corner is the Republican party who say cut spending to reduce future debt obligations. In the other corner is the Democratic party who says that the debt limit should be extended so that it has minimal impact on the economy so that jobs can be created and spending cuts could put our country back into a recession. Who wins? I hope that us citizens eventually win.

Each view has its merits and your view of who is right depends on your perspective. If you are getting a check from the US government you probably are rooting for the Democratic party. If you are the one paying so that another person gets a check you are probably rooting for the Republican party. Everyone wants a balanced budget as long as it does not impact them directly.

Two main points exist in this debate: risk of default and a slowing economy and both impact the interest rates for US Treasury bonds. If a risk of a default exists, then investors will stop buying US Treasury bonds reducing prices and raising interest rates. If the economy slows then investors will start buying US Treasury bonds raising prices and reducing interest rates. You can determine which side is winning by watching the 10 year US Treasury bond interest rate. Since the US Treasury is the largest issuer of bonds this will control the interest rate for the entire economy including mortgages, corporate bonds, car loans, etc.

My perspective is that we will not default on the US debt and we will not slow down the economy. This is high stakes politics and sets fiscal policy for many years and we are the spectators. If we have a risk of default then interest rates go up creating a much larger problem. To illustrate, if interest rates go up by 1% because of this risk on $14.3 Trillion the impact on our budget is $143 Billion annually in higher interest payments. The last thing we need is a $143 Billion rock and the cost of credit for everything we buy will go up. Anyone who is borrowing money wants interest rates to stay low. As far as the impact on the economy, given that the Gross Domestic Product, GDP, for the USA is $20 Trillion if government spending is reduced it will have an impact of a few percent on the economy. I believe that private spending continue to increase regardless of US government spending.

What is the bottom line? The threat of a default risk will take the price for US Treasury bonds higher lowering interest rates. This means that investors should avoid buying US Treasury bonds and any mutual fund that invests in US Treasury bonds right now. Also, if the default risk becomes serious, my recommendation is to get out of all mutual funds that invest in any type of bond and go into cash until this blow over.

This is a fairly complicated topic. Please contact me if you have a question or a concern.

Trivia,

“The taxpayer - That's someone who works for the federal government but doesn't have to take the civil service examination.” Ronald Reagan

"If you put the federal government in charge of the Sahara Desert, in five years there would be a shortage of sand.” Milton Friedman

More than half of the coastline of the entire United States is in Alaska.

The Amazon rainforest produces more than 20% of the world's oxygen supply. The Amazon River pushes so much water into the Atlantic Ocean that, more than one hundred miles at sea off the mouth of the river; one can dip fresh water out of the ocean. The volume of water in the Amazon River is greater than the next eight largest rivers in the world combined and three times the flow of all rivers in the United States.

Istanbul, Turkey, is the only city in the world located on two continents.