Now that Congress has approved raising the US national debt ceiling I'm guessing my clients and readers might have a few questions. As we learn more I'll keep everyone updated, but for now here's a few questions I've gotten so far and the answers based on what information is publicly available:
What does the new debt ceiling agreement provide?
The new debt ceiling measure approved by Congress on Tuesday will cut nearly $1 trillion from the Federal budget over 10 years, raise the country’s debt limit in two installments and assign a special congressional committee to identify additional savings by November. More importantly, it assures the financial markets that the United States will avoid default on its debt obligations.
Does this mean the United States will avoid a lowering of its credit rating?
Not necessarily. While this agreement is an important step forward for Congress, there remains a possibility that credit ratings agencies, like Standard & Poor’s (S&P), may lower the country’s credit rating. While many economists say that such a move is already priced into the markets, meaning that it may not significantly increase volatility, its possibility still leaves a veil of uncertainty over the markets for many investors.
What if trading gets too volatile – are there protections built into the markets?
- Yes. A number of exchanges, such as the New York Stock Exchange (NYSE) and the Chicago Mercantile Exchange (CME), have “circuit breakers” built in to their system. These circuit breakers work in a somewhat similar way to the electrical circuit breakers in your home: stopping activity before an overload. If the market drops below a certain point (say, 10% of the value of the DowJones Industrial Average), that triggers a pause in trading, designed to provide investors with a chance to “assimilate incoming information and the ability to make informed choices during periods of high market volatility,” according to the NYSE.
- Additionally, the Securities and Exchange Commission (SEC ) has also adopted circuit breakers on individual securities, imposing a uniform market-wide pause in trading in individual stocks whose price moves 10% or more in a five-minute period. The trading pause, which was proposed by U.S. exchanges and the Financial Industry Regulatory Authority (FINRA), is limited to stocks in the Standard & Poor’s 500 Index, the Russell 1000 Index, and to certain exchange-traded products.
From a larger economic perspective, what might the ramifications of a credit downgrade be?
- No one can say for certain. Some economists feel that the effect of a credit downgrade may not be extensive. However, it is possible that investor confidence in U.S. Treasuries could decline, which could impact sentiment in the bond market and the broader equity markets. There could be another market correction, meaning that market prices could drop, at least temporarily. And there could be high volatility and sharp market movements.
- Long-term Treasury rates could increase and impact other interest rates, from mortgages to corporate borrowing, which in turn could impact businesses and companies across the globe. In addition, as a result of higher rates, consumer confidence and spending might decline, and there could be lower economic growth for a period of time.
I'll post more information as it becomes available. As of today, the markets don't much care for the debt ceiling increase. The market plunged, interest rates dropped, gold rallied, and investors around the globe are still in panic mode. We've been conservative all along and plan to stay that way, but wouldn't be surprised to see the markets recover nicely in the short term (ie, for a day or two) only to struggle for the next couple of years. Again, more on that at a later date.