The Debt Limit and Beyond

sterner queenMaybe we need a stern, bossy matron in D.C. to “kick some butt.” Barron’s pointed out Saturday that back in 1975, the Australian government shut down in 1975 over a budget impasse. Queen Elizabeth II (queen of Britain and Australia) came in and fixed the problem. She and the local governor-general fired the prime minister, passed a temporary funding bill, and held elections to replace the culpable Parliament. Australia hasn’t had another shutdown since.

Since that time, our American politicians have shut down our government 18 times. This time, the stock market seems to be treating the shutdown like the boy who cried wolf. Investors have seen this show before and the markets haven’t dropped. In fact, it appears that the current debacle in D.C. has some convinced that QE “tapering” is even further off, and therefore, it’s “a great time to buy.”

As we have pointed out in previous blogs, one of the greatest assets, if not the greatest, we have in America is the fact that Treasury debt is the only risk-free asset in the world. It’s the backbone of the world’s financial system. China and others invest their money in Treasury bills. Today, the U.S. dollar is not even close to being unseated as the world’s primary reserve and trading currency. Can you imagine how the world would be viewing our mess in Washington if the worldwide currency was not U.S. dollars? We certainly wouldn’t be borrowing 10 year money to finance our deficits at 2.70%. We might be paying twice that rate and increasing our annual deficits commensurately.

We’re all hoping that an agreement is put in place by October 17th. If not, the government loses its borrowing authority and it can only pay out the cash it has on hand. By the end of the month, that would mean the U.S. could miss a bond payment, which would create a huge mess. The banks rely on treasuries to trade with each other overnight. If you take away trust in the financial system or U.S. debt, it would be, as Joe Nocera on NPR Saturday expressed, “cataclysmic”. In Mr. Nocera’s worst-case scenario: “The banks would freeze up. There will be no borrowing. It’ll be like Lehman. The stock market will go down. It has the potential to be a real disaster.”

Certainly, we all hope and expect that our government will pull us through this short-term mess once again in the next couple of weeks. However, at some point in time, people worldwide may stop trusting the dollar. At that point, it will lose its advantage as the world’s only risk-free currency. Then, America will be on the same slippery slope as many countries around the world are today.

Yes, wouldn’t it be nice to have a stern, bossy matron to “kick some butt” in D.C.? If she isn’t coming soon, perhaps, as NYT writer Thomas Friedman and the Rootstrikers group have suggested, we should push for a third major political party. Two days ago, a Gallup poll showed 60% of Americans, disgusted with Washington, would support this option. Let’s hope it happens, sooner rather than later.

The Underwater Beach Ball Effect

beach ball underwaterRemember as a kid holding a beach ball underwater, then letting it go? It’s fun. It’s also quite unpredictable as it returns to equilibrium.

The Federal Reserve is now facing the same task with long-term interest rates. Rates have been artificially submerged since the financial crisis in 2008. Can the Fed curtail their unprecedented monetary stimulus program without major fallouts to the economy and the financial markets?

On May 22nd, Chairman Bernanke told a congressional panel that he did not foresee an immediate reduction to easy money. However, hours later, the minutes from the last Fed meeting were released. These showed a growing number of governors want to start to “taper off” as early as next month. The markets have been rattled since then. The concern is: can the Fed “taper” off the quantitative easing without damage? It would be quite a balancing act. And, we, of course, are in uncharted waters.

Things had been going swimmingly since last September. The Fed has been buying $85 billion in bonds every month, lowering the long-term interest rates and boosting economic growth. The strategy appears to be working. The economy is growing, unemployment is shrinking, the housing market is recovering and the stock market has been soaring. The Fed had promised to keep the program going until there was a “substantial improvement” in the job market. We’re getting close. However, the markets have been spooked for the last seven trading days.

On Friday, U.S. Treasuries posted their biggest losses in more than two years, pushing yields to twelve month highs. The 30-year mortgage rate rose to 3.81% nationwide. Fixed income investments of all types declined in value, particularly currencies and emerging markets.

The S&P 500 has been down over 2% since May 22 and other equity subclasses, such as international, small cap and emerging markets are down even more. Many of the liquid alternative holdings have been flat, however, global real estate is down significantly, and gold is up in the last seven trading days. It’s one of those short periods of time when almost every investment is down.

The good news is that the economy has in fact recovered sufficiently that the Fed is considering tapering off easy money. That’s great. However, at this stage, we have no idea of the timing or the results of tapering. Bond interest and stock prices are connected, though not in a simple way. If bond interest rates rise too rapidly or too high, they will raise the cost of credit for companies and stock prices will be hurt. However, if interest rates are able to return to, let’s say, 5% or 6% that might have little impact on stocks.

focus

So what’s an investor to do? Should you do something or nothing? During periods of stress and volatility we suggest you focus on what you can control and learn to roll with what is out of your control. For example, none of us can control what the Fed does, what the major media report as front page news, interest rates or market actions. What we can control is our long – term investing plan, our asset allocation and the wealth manager we use.

It’s especially important at these times to review your long-term financial goals, risk profile (risk tolerance, risk capacity, and risk perception) and asset allocation. Most portfolios need a diversified mix of stocks, bonds and alternative investments. And, they need an experienced, proactive, trusted wealth manager like DWM, who has protected and grown client assets through volatile periods, just like the one we may be encountering now. Give us a call.