Debt Crisis

The partisan wrangling over the US debt limit has begun to spook the stock and bond markets.  The US Ten Year Treasury Bond yield increased slightly above 3.0% – a modest increase from its July low of 2.88% – and the S&P 500 has declined about 1.5%.  While this is indicative of some concern by the financial markets, the muted reaction demonstrates that confidence remains that the US Government will honor its debts.  Indeed, an impartial creditor of the US should draw assurance from the fact that regaining fiscal stability is at the forefront of current public debate.  It would be much more troubling if congress had simply rubberstamped the increase in the debt limit and business continued as usual. 

Creditors should further be reassured that this political climate has eliminated any possibility of additional stimulus programs and their accompanying increase in debt.  While the rating agencies have threatened a downgrade of US debt, the prospect remains unlikely given the potential regulatory consequences for financial institutions and other entities that depend upon the AAA rating.  If the US Government Debt rating was lowered, it paradoxically may spur a rally in Treasury Bonds if panicked investors sell stocks and other risky assets. 

The Treasury Bond market is of sufficient size that selling of a large enough magnitude to cause material price declines will necessarily lead to an increase in value to whichever types of assets to which the funds flee.  The funds held in Treasury securities have to go somewhere.  The Yen and the Euro are the only other currencies of comparable liquidity and both are currently less attractive than the dollar as these countries have long term fiscal imbalances at least as serious as those of the United States.  Gold and Silver are speculative and trading at record prices.  Furthermore the metals pay no interest or dividends and their current value depends upon continued fear over the integrity of government finances around the world.   Ultimately the US Government will honor its debts and it is impossible to construct a trading strategy around these concerns that does not potentially lead to lost income and capital losses.