Monday Market Calls: The Federal Debt Ceiling and Treasuries

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Includes: TLH, TLT
by: Russ Koesterich, CFA

Call #1: Underweight Long-Term Treasuries

As negotiations continue in Washington over the federal debt ceiling, our calls this week focus on the question: what is the debt ceiling and why does it matter to investors?

The federal government is limited by law as to the total amount of debt it can issue. This limit is known as the debt ceiling. Currently the debt ceiling is $14.3 trillion, an amount that was technically exceeded last Monday. Fortunately, the government can continue to operate and pay its obligations through various accounting mechanisms. Treasury Secretary Geithner has suggested these mechanisms will allow the government to continue to function and avoid defaulting on its existing debt through early August, after which point the government could theoretically default on its Treasury obligations, something that has never happened in U.S. history and would obviously be catastrophic for financial markets.

Most analysts, ourselves included, do not believe this will happen. Instead, similar to the 2011 budget deal earlier this spring, there will be a lot of political drama and the issue will likely go down to the wire. Still, we do believe Congress will raise the debt ceiling before the deadline.

The issue that's holding up what is normally a fairly routine and non-controversial process is a mostly Republican insistence that any rise in the debt ceiling be accompanied by significant spending cuts and long-term deficit reduction. Not surprisingly, there is little agreement between the two parties on how to go about this. There was some hope in the Senate based on a plan by a small group of bipartisan senators, known as the "Gang of Six." Unfortunately, it looks like those efforts recently collapsed over differences regarding Medicare reform.

Despite the collapse of the Gang of Six's initiative, we believe a compromise will be reached in time to avoid any government default, but similar to the 2011 budget deal the compromise will be largely smoke and mirrors and contain little in the way of real deficit reduction. Real deficit reduction will likely have to wait until after the 2012 election, and even then will happen only if the election produces some type of consensus on how to tackle government spending and taxes, which at this point appears unlikely.

The investment implications of all this are twofold. First, in the short term, we believe fears of a default are exaggerated, and thus we do not think the debt ceiling issue represents a significant short-term risk for the Treasury market.

Longer term, the conclusion is the opposite. With the likely end to negotiations over the debt ceiling likely to be something similar to the 2011 budget deal, we believe the continuing inability of Washington to enact real fiscal reform means that large deficit spending is likely to continue over the intermediate term and with it, there is likely to be a continuation of the large supply of Treasury notes and bonds. This supply occurs against a backdrop in which the real, or inflation adjusted yield, on the 10-year U.S. Treasury is around 70 bps, roughly one quarter of the 60-year average. In other words, at a time when deficits will likely ensure record supplies of new Treasury instruments, the price of longer dated Treasury instruments is at a record high. As such, we continue to believe the US Treasury market offers little value and would remain underweight TLT and other long-term Treasury funds over the long-term.

Potential iShares solutions

Underweight longer-dated U.S. Treasury notes and bonds. TLT – iShares Barclays 20+ Year Treasury Bond Fund

TLH – iShares Barclays 10-20 Year Treasury Bond Fund

Disclaimer: Bonds and bond funds will decrease in value as interest rates rise. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.

Disclosure: The iShares Funds are not sponsored, endorsed or issued by Barclays Capital. This company does not make any representation regarding the advisability of investing in the Funds. Neither SEI, nor BlackRock Institutional Trust Company, N.A., nor any of their affiliates, are affiliated with the company listed above.