Last Minute Deal
Just two days before the Treasury’s deadline, Congressional leaders finally agreed on a package to raise the debt ceiling and reduce deficits by $2.5 trillion over the next decade. On August 2, Congress passed the package, and President Obama signed it, narrowly skirting a default on our national debt.
Here’s how the deal works1
- Enacts discretionary federal spending caps worth about $1 trillion in deficit reduction over ten years.
- Increases the debt ceiling by $900 billion (enough to last less than a year’s worth of borrowing needs).
- Scenario 1: Tasks a bipartisan Congressional committee with finding an additional $1.5 trillion in deficit cuts by late November. By year’s end, Congress must vote on and approve proposed cuts to raise the debt ceiling another $1.5 trillion.
- Scenario 2: Triggers automatic cuts (if Congress cannot reach an agreement) that commence in 2013. Cuts would be split 50/50 between defense and domestic spending, excluding Social Security and Medicare. The debt ceiling would be raised by an additional $1.2 trillion, equal to the amount of cuts.
- Requires both the House and Senate to vote on a balanced-budget amendment to the Constitution, but a further increase in the debt limit is not subject to its passage.
Downgrade in the U.S. Credit Rating?
The deal was not enough to avert the first-ever credit downgrade for the United States. The rating agencies (Standard & Poor’s, Moody’s and Fitch) analyze risk and assign the debt a grade that reflects the borrower’s ability to pay back the underlying loans. The safest bets are stamped a triple-A, which has been the U.S. government’s rating since 1917 when Moody’s first issued it.3 S&P had said it was looking for a bipartisan plan with at least $4 trillion of debt reduction,2 and the deal fell $1.5 trillion short of that benchmark. On August 5, S&P dropped our credit rating from a AAA to AA plus, citing concerns that political gridlock may hamper our country’s ability to deal with its long-term debt burden.
The action is likely to eventually raise borrowing costs for the U.S. government. Since government lending rates act as the floor for other lending rates, consumers may pay higher interest rates on mortgages, car loans, student loans and credit cards. State and local governments, alreadyfacing financial struggles, may see their borrowing costs rise. That could force them to make more budget cuts, raise taxes or both. 2
For the federal government, if interest rates rise just 0.7% (the difference between the average AAA-rated and AA-rated countries), it will pay $100 billion a year more to service the national debt.4
Many financial and economic analysts raise concern that America’s ugly debt debate has damaged the stature and standing of the U.S. economy and the U.S. treasury in the world. Global markets have had a “positive bias” toward U.S. treasuries, holding them as the gold standard of safety and security. The concern is that a downgrade may result in foreign debt holders increasing diversification away from U.S. treasuries and moving away from the U.S. dollar as the sole reserve currency over time.5
Market Volatility and Investor Confidence
The government impasse and eleventh-hour timing of the debt ceiling deal have shaken investor confidence. Markets are likely to remain volatile as attention turns back to the overall economic outlook, both here in the U.S. and in Europe.
Many top money managers caution investors to view the situation as another learning moment rather than a portfolio crisis.6
When markets react to short-term events, investors are often better served to remain fully invested over the full market cycle. History shows us that short-term market declines are often followed by rebounds. Trying to time the ups and downs in the market is difficult, and it can be costly.
Weathering risk in volatile markets takes preparation, a diversified, long-term strategy and the confidence to stick with it.
This same approach may serve our leaders in Washington as they strive to curb the deficit and get our nation back on a more sustainable and responsible fiscal path.
Sources: 1) CNN, “Debt Plan Cheat Sheet,” August 1, 2011. 2) Huffington Post, “U.S. Credit Rating Downgrade Looking Likely,” July 27, 2011. 3) New York Times, “Q&A on the Debt Ceiling,” Michael Cooper and Louise Story, July 27, 2011. 4) Bloomberg, Business Week, “U.S. Downgrade May Cost $100 Billion a Year,” JPMorgan Says, July 26, 2011. 5) CNN, “Why America is Now on Probation,” Interview with Fareed Zakaria , July 28, 2011. 6) U.S. News and World Report, “Don’t Panic Over Debt Ceiling Says Fidelity,” Other Advisors, July 28, 2011.
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