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The Debt Ceiling: Failure Makes Everything More Expensive

By David Dittman on July 15, 2011

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As of this writing it’s still rarer than a major league perfect game, a moon landing, a 09/11/01, but a breach of “full faith and credit” grows likelier by the hour. What will happen if the United States Congress doesn’t increase the federal debt limit before Aug. 2? The short answer is “nobody knows, but probably nothing good.” Here’s a (slightly) longer attempt.

The question obscured by all the political drama is, what’s going to happen to interest rates? You can be fairly sure that at least some observers will see some sign of default should the United States Congress fail to increase the federal debt ceiling by Aug. 2. And it’s likely that at least one of the major credit raters will be among them.

But will failure to allow the US Treasury further borrowings to fund continuing operations trigger the type of market-based interest-rate increases not even “QE3” and “QE4” would counteract? There’s no way Treasury Secretary Timothy Geithner won’t pay the coupons on outstanding government debt. These obligations will be met, which will reassure major institutions and countries that hold substantial amounts of US bonds. But he will have to make choices; average spending–minus interest–outpaces revenue by about $118 billion a month.

Secretary Geithner compares this to a homeowner who pays his mortgage but not an auto loan, a credit card or a utility bill. It’s true that those of us running our households would see some sort of grace period were we to fall a bit behind on a couple of those items, without even subjecting ourselves to interest-rate increases. But at some point the price must be paid.

Alternatives to raising the debt ceiling include raising taxes by about USD700 billion by Sept. 30 or acknowledging inability to meet its obligations. The ceiling has to be increased in order to meet obligations that have been created by this and other Congresses; this isn’t about new spending.

We might be about to find out where it is that someone cries “default” at the US government. And this ultimately ideological battle could cost all of us real money.

The Debt Ceiling: Look North for Cover

It’s not enough for investors to sit back and watch the story unfold. Just as politicians make choices, self-directed investors who are interested in building wealth over the long term have to make choices, too. And it’s becoming increasingly clear that among those choices must be foreign equity markets that help American investors hedge the serious risk to capital posed by a potentially weakening US dollar.

This week the C.D. Howe Institute’s monetary policy council recommended that the Bank of Canada (BoC) raised its target overnight interest rate 25 basis points to 1.25 percent when it meets Jul. 19. The BoC and Governor Mark Carney are expected to hold the line at 1 percent, in part because of concern that a rising interest-rate differential between Canada and the US will send the loonie soaring even higher above parity with the buck.

Despite ample evidence that a strong currency has overall positive wealth effects for Canadians–and that the country’s increasingly diverse manufacturing economy has begun to recover–there is still substantial establishment pressure to maintain, as much as is possible through ordinary and sometimes even extraordinary policy, a reasonable relationship with the US dollar. This makes sense, given Canada’s historic ties to its southern partner, with which it forms the largest bilateral trade relationship in the world, still.

But what happens in Canada is becoming increasingly dependent on what happens in China and other emerging markets such as India. It may no longer be possible for Canada to withstand the pressures its relative health–based on its abundant resources and strong fundamentals–bring to the US dollar-Canadian dollar relationship. In the July Canadian Edge Feature Article I suggested that upside catalysts might be few, far between at this point and unpredictable. Discussing CurrencyShares Canadian Dollar Trust (NYSE: FXC) in a piece focusing on closed-end and exchange-traded funds, I noted that the ETF

is redundant if you hold a significant amount of investments that pay dividends or generate substantial income in Canadian dollars. If you’re long the CE Portfolio, you’re long the loonie, which is what this ETF gets you.

Its price will track closely the relationship of the Canadian dollar to the US dollar. Although the long-term foundation of the Canadian economy is sound and there are continuing question about US fiscal, monetary and economic policy, there are few catalysts save those of the “black swan” variety to stimulate much more upside from here.

Parity looks set to hold for a while.

Well, potential failure of the US Congress to raise the federal debt ceiling qualifies.

The Debt Ceiling: Is the Difference a Sound Economy?

They aren’t having the kinds of political debates in Canada the outcome of which threatens to shut down the federal government, put a stop to Social Security payments and send the US debt rating hurtling toward junk status.

It’s safe to say that if the unemployment rate in the United States was even 7.4 percent, as it is in Canada, we wouldn’t be suffering these types of ultimately pointless charades. The bitter irony of this tragicomedy is that the solution certain hardliners appear to support would accelerate the destruction they claim to be fending off.

This being a solutions-based operation, we offer the following contrast between the results of separate surveys of business leaders on both sides of the US-Canada border.

The BoC’s quarterly Business Outlook Survey, which polls 100 Canadian leaders about conditions they’re experiencing, found that most were optimistic about sales prospects over the next year and are also enjoying easier credit conditions. Managers reported the most robust hiring intentions on record.

Sales growth strength rests mostly in Western Canada and demand for resources. But efforts to increase competitiveness–long a weakness for Canada relative to other developed economies–are paying off, as business leaders across most regions and sectors reported plans to increase employment and investment.

Meanwhile, a survey conducted on behalf of the US Chamber of Commerce found that 64 percent of companies with income of USD25 million or less don’t plan to hire more employees over the next 12 months. Just 19 percent of small businesses said they planned to add new employees. But there is some encouraging news in what remains a bad employment economy: Only 12 percent said they expected to lose workers in the next year, well below the 29 percent who said they lost employees over the past year.

Just because it hasn’t happened before doesn’t mean it can’t, and the perception or the fact of failure to extend the US federal debt ceiling won’t have much impact on the short- or medium-term direction of the economy. Markets are likely to react, however, and that means investors must be prepared. Diversifying a part of your portfolio via high-yielding Canadian stocks is one way to protect against whatever craziness the debt ceiling continues to stoke.

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