What Will Happen When Debt Ceiling Isn't Raised?

Includes: DIA, GLD, TLT
by: Katchum

The government shut down on October 1, 2013. Some 800000 government workers are sent home without pay, but might get paid if a bill is created and passed to pay them for their lost time. During the last shutdown, in 1995 and 1996, Congress later passed legislation that made workers whole for the days they were furloughed. But today, at least 535 federal workers at Congress will get paid, for doing nothing, except for sabotaging the country's core. It is estimated that the GDP would decline $1.6 billion/week or $83 billion/year. The U.S. GDP growth is 2%/year or $300 billion/year. So for example, if the government would shut down for a month, it wouldn't be growing 2%/year, but 1.8%/year. Hardly noticeable...

On the other hand, we have a more significant date: October 17. This is the day where the debt ceiling will be breached. That's a more serious thing to consider. When the debt ceiling isn't raised, there is the imminent problem of maturing debt. The short-term maturities are going to be the ones that default first. Chart 1 gives the T-bills with their maturity date. Those that mature on October 17, have a spike in yield. You will see that those yields are skyrocketing every day closer to the debt ceiling default date of October 17. So the market is anticipating an outright default. This will have severe implications on credit transactions all over the world as noted by Bill Gross.

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Chart 1: Yields on T-bills with their maturity date
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So what will the Federal Reserve do if we were to breach the debt ceiling, instead of raising the debt ceiling? First and foremost, the Congress cannot issue any new debt. The Federal Reserve can still buy maturing debt that is outstanding though. At this moment the Federal Reserve owns some 32% of the total outstanding bonds, so it can still buy the bonds that nobody wants. The only problem is that the Treasury Department can't increase the supply of bonds that are outstanding. There is therefore only one thing to do, printing more money and increasing the amount of QE instead of tapering. In fact, there will be no chance of tapering as I already wrote here. The Federal Reserve will buy up all defaulting debt/bonds and all the defaulting interest payments that come with it. There is no way that foreigners won't be paid as this will undermine the U.S. dollar as reserve currency.

Also remember that the Federal Reserve mostly holds Treasuries with long-term maturity (+5 years) and is monetizing 90% of this debt. If the default comes, it will have to come to the rescue for the shorter-term maturing bonds too, which are mostly held by foreigners. To keep yields low, the Federal Reserve would have to increase QE to buy these defaulting bonds.

All in all, the end result is a declining U.S. dollar. We already note that the U.S. dollar index has gone below 80 and I expect that to continue declining due to the debt impasse (Chart 2). A declining dollar index is a very good indicator for rising U.S. Treasury yields and rising current account deficits to come.

Chart 2: U.S. dollar index
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All of the above can happen, but I believe that the debt ceiling will be raised as always. The new debt ceiling is likely to be in the range of $17.8 trillion to $18 trillion, assuming GDP will continue to grow at current rates. This will make sure that obligations are met till December 2014 (Chart 3).

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Chart 3: U.S. Public Debt
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The steepness of the debt curve will depend on many things. Rising yields will increase the steepness of the curve because of higher interest payments. Rising yields will also be negative for the housing market, which results in less in dividend payments from Fannie Mae and Freddie Mac to the U.S. Treasury. The amount of dividends that will be paid is the equivalent of Fannie Mae and Freddie Mac's net worth in the previous quarter less a $3.0 billion capital reserve, which will be reduced by $600 million annually (so in 2014 the capital reserve will be $2.4 billion) until it reaches zero in 2018. As mortgage rates are now rising, we will see that the net worth will start to plunge, which means less dividend income going to the U.S. Treasury and higher deficits. As of September, the two companies will have paid the U.S. Treasury $146.2 billion in dividends, but that won't be sustainable if mortgage yields go higher. To show that this is actually becoming reality, I point to the recent bailout of the Federal Housing Administration (FHA). This bailout was exactly the consequence of rising interest rates and is only the first part of a series of events yet to come.

The conclusion is that the Federal Reserve has started to lose control of the bond market. We're spiraling into a debt crisis and I believe we haven't seen the worst of it yet. Whether the debt ceiling will be increased or not, I think we have hit a top in the stock market due to high valuations, a top in the bond market (NYSEARCA:TLT) due to the debt impasse and a bottom in the gold market due to high physical demand. As the equity market and the gold market are currently inversely correlated to each other I would sell equities (NYSEARCA:DIA) and buy precious metals (NYSEARCA:GLD).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.