Debt Ceiling Investing

The US economy isn’t exactly going great guns, but it may have just dodged another bullet.

Republican leaders in the House of Representatives are now willing to lift the debt ceiling by enough to keep the government current on its obligations for almost three months. Their only remaining condition is that the Senate pass a budget. The two squabbling legislative chambers still might find no acceptable compromise, triggering a debt default.

But probably not. “We defaulted because they wouldn’t show us their budget” isn’t a crowd pleaser.

Delayed Social Security or bond interest payments also didn’t figure to make Republicans more popular, so once President Obama called their bluff and said he would take no unilateral action to pay the bills, there was nothing for the House to do but to play out a losing hand or fold.

If you fold you may get to play a better hand, and proponents of austerity do have a couple of obvious aces up their sleeve.

The first is the sequester meant to cut the budget by $1.2 trillion over the next 10 years, kicking in March 1 as a delayed consequence of the prior budget ceiling increase.

The other is the March 27 expiration of the continuing resolution funding the federal government, requiring a fiscal compromise to keep government offices and museums open.

Both of these deadlines are much friendlier to spending foes than the threat not to raise the debt ceiling, which offers no positive outcome and might conclusively brand the Republican Party as irresponsible.

In contrast, the sequester and the government shutdown would begin by default in the absence of a bipartisan bargain, would be less likely to cause a financial panic and would allow pensioners and soldiers to be paid even as the hated government is hamstrung.

Europe’s Bad Example

So this is a tactical retreat, nothing more, in the battle over federal spending and taxation. And it’s a battle that austerity will win because neither party has looked hard enough at what’s been happening in Europe.

There, tax hikes and spending cuts have undermined consumer and business confidence, depressing the economy. The resulting recession has left governments with less, not more, revenue and a mounting bill for unemployment benefits.

The hike in payroll taxes on workers and income taxes on the wealthy passed this month has already cut 1 percent from this year’s expected economic growth. If the sequester cuts go forward, and you’d have to be quite the optimist at this point to think that they won’t, the economy loses another 0.8 percent. So that’s a combined 1.8 percent taken out of the gross domestic product before we even get to the Republican price for funding the government and extending the debt ceiling past April.

This is a bit higher on the pain threshold than the austerity Britain has recently had to endure. And Britain’s economy is about to register a triple-dip, still mired in a recession seemingly without end. Another round of US budget cutting this spring would push the punishment meter closer to Italy’s level of abnegation, and Italy’s economic downturn is only deepening.

That’s a lot of lost sales and jobs for the private sector to make up, and Europe’s example shows that as government spending shrinks, private investment and consumption also tend to curdle. The US housing recovery and energy boom should keep the economy out of a recession. But growth is likely to once again prove disappointing.

Two Ways to Play the Slowdown

That would likely cause long-term interest rates to head lower again, reversing the recent rebound. Debt default scaremongering aside, no asset can match the safe-haven appeal of long-term US debt, and no asset will be scarcer in 2013.

There’s a shortage of assets with assured nominal cash flows in the financial arena, as can be seen in the shriveling yields of corporate bonds, investment grade as well as junk. At the same time, the US budget deficit is likely to shrink from $1.1 trillion in 2012 to perhaps as little as $900 billion this fiscal year, which would cut the US government’s debt issuance by 18 percent.

The economic weakness caused by these budget cuts is likely to keep the Federal Reserve buying a rising proportion of US debt. At the current rate of $40 billion in government bond purchases a month, the Fed would by the end of the year end up owning more than half of the 2013 debt issued by the US.

My favorite play on those themes is the Pimco 25+ Year Zero Coupon US Treasury Index (NYSEArca: ZROZ), a tradable and relatively liquid exchange traded fund (ETF) duplicating the performance of 30-year US Treasury strips.

These are bonds stripped of their payment coupons and discounted accordingly, so that the entire return is collected at maturity. The ETF, of course, can be sold any time and pays a 3-percent-plus yield instead.

The strips and proxies like the ZROZ are more sensitive than the plain-vanilla bonds to changes in interest rates, appreciating faster as rates drop. Barring a robust economic recovery, the financial deck is stacked in their favor, and Congress figures to keep the economy on ice in its misguided push for austerity.

The US dollar would be also benefit, notably in relation to an unsustainably expensive euro. Europe’s fundamental problems remain unresolved, and the recent speculative rush into the Italian and Spanish stocks and bonds is liable to reverse sooner or later, at a moment’s notice. Austerity in the US would only make Europe’s economic problems worse, exerting more downward pressure on the euro.

The ProShares UltraShort Euro Fund (NYSEArca: EUO) gains on a daily basis double what the euro loses against the dollar, and loses twice as much when the euro rallies. Austerity on both sides of the Atlantic would likely give this ETF a nice lift from the current 14-month lows.

Igor Greenwald is an investment analyst with The Energy Strategist and Personal Finance.