On Your Mind: Debt Ceiling and the US Dollar
by the Schwab Center for Financial Research
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.
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 does this mean for investors?
Outlook for the US dollar
- Is there a risk of the dollar collapsing in the short term?
- Is the world going to abandon the dollar as a reserve currency?
The US debt ceiling
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. That said, the situation illustrates the importance, we believe, of a global, broadly diversified portfolio.
What are the chances of the United States defaulting on its debt?
We believe a default is 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 its cash-flow management strategies will run out and it will either need to issue new debt above the limit (which it can't legally do) or stop payment on a variety of obligations, including 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, but as of yet no there's no legal prioritization for 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. However, we believe that the debt ceiling will be raised, allowing the government to avoid suspending payment to its bondholders or to anybody else.
When can we expect a resolution to this issue?
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 it is very likely to happen.
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.
What does this mean for investors?
For the moment, we see less upside and more risk in new Treasury purchases for price-sensitive bond investors. 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 for most investors.
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.
It's true that we've seen a recent increase in yields, which we believe has to do with the debt-ceiling debate as well as many other variables: the ongoing challenges in Europe and, specifically, Greece; changing market consensus about the pace of US economic recovery; and the recent end to the Federal Reserve's bond-buying program (QE2).
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.
Is there a risk of the dollar collapsing in the short term?
A sudden sharp decline of the dollar would not be in anyone's interest. This includes Japan and China, which are the largest external holders of US Treasuries. It would destroy the value of their massive foreign currency reserves that are heavily overweight in dollars. Sudden sharp moves in exchange rates are generally seen as a threat to the stability of economies and global financial markets. Were the dollar to suffer a sharp decline, it would most likely lead to concerted currency market interventions similar to the recent G7 intervention to stabilize the yen.
Because the whole world is so dependent on the dollar, no one wants violent moves in the currency. Therefore, a possible shift away from the dollar is likely to take place over several years or even decades and not in the near term. This will give you time to assess your portfolio and the changes you might want to make.
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. 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.
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.
