Wednesday, July 27, 2011

Debt Ceiling Impasse

Yesterday The Dow Jones Industrial Average fell for a third day in a row, the dollar slumped and gold hit a new high.  Clearly the debt ceiling deal impasse between the White House and Congress is weighing on the markets.


Without a deal, the most feared scenario is that the U.S. will miss payments on its bonds and default — which financial experts say would be disastrous. While still considered unlikely, the prospect is popping up more in conversations.


"No one … could possibly say that there is no chance of a catastrophic outcome," JPMorgan Chase & Co. CEO Jamie Dimon told analysts last week of the debt ceiling negotiations in Washington.


The more likely scenario that investors are preparing for is that a temporary deal is struck to lift the debt ceiling. But such a makeshift plan is unlikely to allow the U.S. to maintain its AAA grade with bond rating companies. Citigroup analysts say the odds are 50-50 that the U.S. will be demoted to an AA rating for the first time ever.


Such a downgrade could lead to a temporary market disruptions. In the longer term it could push interest rates up for everyone from bankers down to ordinary people taking out car loans, and weaken the dollar's position as the world's reserve currency.


Meanwhile, bond rating company Moody's Investors Service warned Tuesday that the impasse in Washington threatened money market mutual funds. The investments are required to hold high-quality securities, including Treasury issues, and could be hurt if the government misses an interest payment on its debt.


Clearly, defaulting on the debt would be a disaster.  It would reverberate though all asset classes.  Institutional investors (China) would likely reduce their Treasury holdings, driving prices down and interest rates up. The exchange rate of the dollar would likely be depressed driving up the cost of all imported goods (oil).  Gold would be pushed even higher.  Mortgage rates would be driven higher, further depressing the fragile real estate recovery. Financial prognosticators are talking about a 2% to 10% further downturn in the stock markets.  Everyone hopes that a default is avoided, but at this point market participants are unwilling to rule out the possibility.


Think shutting down the Federal government is a good idea?  Think again.  A typical State budget depends on federal funding for 30% to 40% of their total spending.  At a time when revenues are depressed and most  states are dealing with budget deficits, a shutdown of the Federal government would cut off this source of funding and likely result in a fiscal crisis.



John Broussard

Assistant State Treasurer

Chief Investment Officer

State of Louisiana

Department of the Treasury


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