Debt Ceiling Deal: Damned if They Do, Damned if They Don't

The deadline for Congress to raise the debt ceiling is drawing close (the Treasury is expected to run out of money sometime between Aug. 2 and 10), but the issue seems to be diminishing in importance for investors. The emerging consensus among them runs along the lines of: Damned if Congress does, damned if it doesn't.

Even if the debt ceiling is raised, which is still seen as extremely likely, the new thinking goes, there is a strong possibility that U.S. government debt will lose its AAA credit rating sooner or later. That prospect has made a deal to reduce the fiscal deficit the more acute priority of Wall Street.

As noted in a post on Monday, Bank of America Merrill Lynch Global Research sees a downgrade as "likely." Others, like Citigroup, judge the odds to be 50-50.

The risk of a downgrade has been a hot topic in Wall Street commentary during the last few days, and it's the subject of an open letter Monday to President Obama and Congress, imploring them to come to an agreement that will "reduce the deficit substantially." Here is a passage from the letter, signed by investment management firms like BlackRock and Legg Mason and several public employee pension systems:

We're Number 7?
"As a debtor nation, America must show the world that the nation's word is its bond. Raising the debt ceiling is vitally important, but that alone is not enough. The huge budget deficit, both current and long range, must be dealt with urgently as well. Addressing the current federal debt ceiling crisis, by itself, will not fix the entire problem. We would be deluding ourselves as a nation. If we want strong economic growth and job creation we must fix the deficit for real, for good, for the future of all Americans.
"As custodians of Americans' savings, we urge Congress and the administration to reduce the deficit substantially. Without a credible action plan to reduce the budget deficit, the U.S. debt will likely be downgraded by one or more rating agencies. The idea of America losing its AAA rating was once unthinkable, but now highly likely if our leaders fail to act. If that were to happen, six countries, including France and Germany, will have credit ratings above that of the United States, signaling America's diminished ability to pay its debt. And, make no mistake about it: the consequences of such a downgrade are very real and very serious."
It's hard not to agree with the argument made in the letter. It's also hard not to notice that it was written by the caretakers of a few gazillion dollars' worth of bonds whose value depends on a deal that reduces the debt enough to maintain the AAA U.S. credit rating.

Only the First Domino
There's nothing wrong with bond managers wanting to preserve their investors' capital; they would be fired or sued if they didn't. And a downgrade of U.S. debt would have ramifications beyond the value of their portfolios.

It's customary for rating agencies to rate the debt of any issuer in a country no higher than the debt of its central government, so other AAA debt probably would be downgraded. Some students with government-guaranteed loans might get a rude introduction to economics, too, because some lenders insist that loan guarantors have a AAA rating.

The problem with avoiding a downgrade at all costs is that it makes it more likely that one of the costs will be a significant tax increase. An accord that narrows the deficit that way would help to prevent a downgrade and keep bond owners happy, but it probably would be viewed in markets and personnel departments as an impediment to badly needed economic growth.

The focus of investors' anxiety has shifted from raising the debt ceiling to narrowing the deficit. Unless that goal is accomplished in a way that is seen to nurture long-term growth, the anxiety is likely to shift again, not go away.