On Your Mind: Debt Ceiling and the US Dollar
Charles Schwab
By Team
July 18, 2011
There's been a lot of media attention on the US debt ceiling and the outlook for the US dollar. Here, we'll answer some of the questions we've been receiving from clients. As always, if you have questions about individual investments or your portfolio, please talk with your Schwab financial consultant.
The US debt ceiling
- What are the chances of the United States defaulting on its debt?
- Will the United States automatically default if the debt ceiling isn't raised by August 2?
- When can we expect a resolution to this issue?
- What will happen if the United States does default?
- What are the chances of a downgrade of the United States' AAA rating?
- What would a default mean for bond investors?
- What would a downgrade mean for bond investors?
- What are the implications for the stock market of a downgrade or short-term default?
- What is the likely impact on the dollar in the short term if the debt ceiling isn’t raised?
- Is the world going to abandon the dollar as a reserve currency?
We believe that there will, in fact, be a resolution to the debt-limit debate, and that default on US Treasury debt remains unlikely. The United States has a resilient economy and a strong ability to pay, despite the current political debate.
What are the chances of the United States defaulting on its debt?
We believe that a default remains extremely unlikely. We expect that the political debate will continue, but believe that the negative consequences, both political and economic, will become more apparent the longer the delay. According to the Treasury, those consequences could include delay of Social Security payments, Medicare, military salaries and other expenses, and ultimately default. As the deadline approaches and the potential pain becomes more apparent to the average citizen, or is reflected in a rise in yields, we believe that politicians will act and raise the debt ceiling.
Will the United States automatically default if the debt ceiling isn't raised by August 2?
If the debt ceiling isn't raised by August 2, the Treasury has stated that it will need to stop payment on a variety of obligations, including potentially, debt payments. A default could be staved off for a short time if the federal government prioritized payments to bondholders over paying its other bills. It's unclear how this would be managed, but as of yet, there is no clear legal prioritization of payments. Given the enormous amount of interest and principal due on the federal government's outstanding debt, this temporary solution wouldn't be sustainable for long. Ultimately, the debt ceiling would need to be raised to allow the government to avoid suspending payments on Treasuries as well as Social Security, military paychecks and a host of other government payments.
When can we expect a resolution to this issue?
According to Schwab legislative analysts in Washington, a deal would probably need to be made no later than July 22 in order to meet the August 2 deadline for completed legislation. Once the broad outlines of a deal are agreed upon, it normally takes two to three weeks to hammer out the specifics and produce draft legislation. That schedule would likely be compressed here, given the urgency of the situation. Once draft legislation is complete, both the House and Senate must vote to approve it—and this may be the trickiest step of all. President Obama and House and Senate leaders will have to forge bipartisan coalitions in both chambers to get the bill across the finish line. We believe that this will be difficult, but that some resolution which at least allows a temporary increase to the debt limit or payment on debt remains likely.
What will happen if the United States does default?
It's impossible to say with any degree of certainty because this has never happened before. The three major bond rating agencies have said that they would lower the US's current AAA rating even if interest and principal payments were interrupted for only a few days. Should this occur, we still expect that global demand for Treasuries and confidence in ultimate payment won't disappear. Treasury yields would likely rise in the event of a default, and we expect more volatility in Treasury yields until an agreement is reached. To date, however, Treasury demand has remained strong, and yields near historical lows. The US has the financial and economic ability to pay on current obligations, supported by global demand for US Treasuries. The matter has been more of a political debate using the debt ceiling to help reduce the long-term deficit.
What are the chances of a downgrade of the United States' AAA rating?
Standard & Poor’s and Moody's Investors Service have recently put the United States' AAA rating on a negative watch with potential for a downgrade. Both expect a default to remain unlikely, though the possibility of a short-term default increases as the politics look more difficult. The chance of a rating downgrade of the US bond rating from AAA from one of the major ratings agencies has increased. S&P has said that the chance is "one-in-two" over the next 90 days. S&P has also been saying more clearly that it might lower the US rating, probably to somewhere in the AA category, if there isn't meaningful progress on deficit reduction. Whether it does lower the rating or not will likely depend primarily on a credible deficit reduction plan and willingness to meet existing to meet existing obligations.
What would a default mean for bond investors?
We see less upside and more risk in new Treasury purchases for price-sensitive bond investors now. However, we believe that buy-and-hold investors should remain confident that US capacity to pay will ultimately remain strong. We don't believe that a dramatic change in investment strategy is warranted.
Fundamental demand for US Treasuries has remained strong, as evidenced by yields that remain near historical lows. This, we believe, is due to a number of factors, including:
- Confidence that the debt limit will be raised
- Weaker economic data leading to continued demand for Treasuries
- Some positive sentiment (toward Treasuries) that a serious budget/deficit debate will lead to a strong US fiscal position
- Some negative sentiment (toward the economy) that large and/or rapid cuts in government spending might slow economic growth in the short term.
What would a downgrade mean for bond investors?
If the United States' AAA rating is lowered, there could be some short-term disruptions in bond markets. The typical market reaction to a ratings cut is a rise in yields. We expect that we would see some volatility in Treasury yields, possibly shifting higher. However, since there is no historical precedent, nothing is known with certainty. Given the credit problems in Europe and the slowed pace of growth globally, demand for US Treasuries has remained strong. US Treasuries rated AAA are also an important source of high-quality collateral and a benchmark for credit quality and liquidity. At this time, it is difficult to know the magnitude of this impact or stress.
What are the implications for the stock market of a downgrade or short-term default?
The stock market does not appear to be pricing in a high likelihood of major economic disruption based on the Treasury market or the debate in Washington. The possibility of a credible deficit reduction plan may actually be as positive. However, if we did approach the August 2 deadline without much more progress, we’d expect a higher probability of market volatility. The magnitude is harder to know, though not likely a positive. Markets are generally resilient and likely to reflect the underlying fundamentals of individual companies and the health of the US economy, especially once the short-term political issues become clearer.
Outlook for the US Dollar
Recent events have caused some investors to wonder about the dollar's short-term prospects and its status as a world reserve currency. While there are genuine reasons for the dollar's weakness—including large deficits, a loose federal monetary policy, and a less-than-robust economic recovery—we believe that a sudden collapse of the dollar or a precipitous change in its reserve currency status is unlikely. Additionally, we believe that a global, broadly diversified portfolio can help investors protect US-denominated portfolios from a dollar decline.
What is the likely impact on the dollar in the short term if the debt ceiling isn't raised?
The uncertainty surrounding the upcoming decision on the debt ceiling has been a negative factor for the dollar. A US default and/or a downgrade of the US credit rating would almost certainly be negative also. It could weaken confidence in the dollar and cause it to fall. However, there are many global factors driving demand, including support of Japan and China, which continue to be large holders of US Treasuries. It would not be in their interest to sell dollar-denominated assets, including Treasuries, if there was simply a rating change or short-term default.
Is the world going to abandon the dollar as a reserve currency?
It's unlikely that the dollar will lose its status as the world's number one reserve currency anytime soon, even if the debate in Washington about the debt ceiling and payment on US Treasuries escalates. Talk of creating new supra-national currencies or even a global fiat currency has gotten louder due to recent events and negative sentiment toward the US Fed's monetary policy. But even if there is a will to work toward creating new currencies, the countries involved are nowhere near realizing those plans.
No other existing currency can offer the necessary stability and liquidity to replace the dollar as the world's reserve currency in the foreseeable future. This suggests that the dollar will keep its status for now. Long-term deficit reduction plans could help stabilize this role over the longer term relative to other developed market currencies.
In the mid- to long-term, however, we believe it's possible that the dollar will eventually share its reserve status with other currencies such as the euro, the yen and maybe even the Chinese yuan. The creation of new currencies is also possible. However, keeping the euro area's difficulties in mind, the success of such endeavors first has to be proven, and takes time.
Important Disclosures
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative (or "informational") purposes only and not intended to be reflective of results you can expect to achieve.
Diversification does not eliminate the risk of investment losses.
(c) Charles Schwab
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