There is no shortage of respected investors, CEOs, and world leaders who have urged the U.S. to raise the debt limit before the August 2 deadline.  Failing to do so, Warren Buffett said, would be "the most asinine act ever."  Others have been less candid with their remarks, yet the basic contention is that a failure to raise the debt ceiling from its current $14.3 trillion limit before August 2 would prove disastrous for financial markets and the economy, meaning ultimately that it is not an option.

Apparently, though, it is.

Some sitting members of Congress think everything will still be okay if the debt ceiling isn't raised by August 2.  Interest payments on U.S. debt, they say, could still be made.  That is true, assuming of course that there is a trade-off between servicing the debt and not sending out Social Security checks for instance (which should go over really well in swing states like Florida). 

In any event, there is a big issue at hand and it does not sound as if the politicians in Washington are in a compromising frame of mind -- at least not yet anyway.  Ideological views are strong on both sides of the aisle, particularly since a decision to raise the debt ceiling has now been tied to getting our deficit under control.

We Are "Here"

Raising the debt ceiling is nothing unique.  According to the Office of Management and Budget, Congress has passed 78 separate acts since 1960 to raise the debt limit, extend the duration of a temporary increase, or revise the definition.  That amounts to more than one act per year on average over the last 50 years.  There have been ten increases alone since 2002 in which the debt limit has increased from $6.4 tln to $14.294 tln. 

What is unique today is that the fiscal standing of the U.S. is weaker than it has ever been over that period.  Actually, it is nearly the weakest it has been in the post-World War II period.  The latest projection by the CBO indicates the budget deficit will amount to 9.5% of nominal GDP in 2011.

With the latter in mind, there is certainly a valid argument for needing to cut the deficit in a meaningful way.  The heated topic of the current debate is whether this is the time and the place to take on that effort. 

Should an agreement to raise the debt ceiling be held hostage by partisan views on how to cut the deficit that risk inviting a possible default on U.S. debt?  The answer to the last question is irrelevant, because the fact of the matter is that we have reached that point.   We are "here," as navigational maps indicate, only no one really wants to be "here."

Forecasts of financial and economic doom if the debt ceiling isn't raised are daunting.  So, too, are forecasts for the deficit if spending isn't cut and entitlement reforms are not made.

Where we go from here is the great unknown, although experience suggests an eleventh-hour deal will be reached to raise the debt limit and avoid having to test the previously unheard of possibility of the U.S. defaulting on its debt.

Banking on Experience

The equity and bond markets appear to be riding the rail of experience.  Despite the fatalistic prognostications associated with not raising the debt limit before August 2, there are few, if any, signs of abject fear in either market about not raising the debt limit in time. 

Sure, the stock market has acted a little cagey of late, but that has had more to do with the debt crisis in the eurozone and softening economic data than it has had to do with the potential debt crisis in the U.S.   Even so, the S&P 500, after rallying 30% between September and April, is down just 4% from its 52-week high.

The Treasury market for its part continues to attract new money, which is striking considering it would be at the epicenter of the U.S. defaulting on its debt. 

The yield on the 10-year note has dropped nearly 80 basis points since early-February to 2.97%.  In fact, the yield on the 10-year note today is roughly 120 basis points lower than it was at the end of 2007 or before the U.S. ramped up its stimulus spending to help cushion the blow of the financial crisis and the Great Recession

The behavior of the Treasury market in particular is what has emboldened some pundits to suggest the concerns about not raising the debt limit before the August 2 deadline are overblown.  The resilience of the euro and the surge in gold prices, however, could be held out as reasonable proxies when it comes to concerns about the debt limit issue.

We think the relative strength in the equity and bond markets has been predicated in part on three beliefs:  (1) that an eleventh-hour deal will be reached (2) that, even if a deal isn't reached in time, a perverse reaction in the capital markets would quickly produce an agreement in much the same way the original "no" vote for TARP, and the subsequent plunge in the stock market, did and (3) that the Fed will unleash emergency measures to keep liquidity flowing.

What a strange framework from which to operate when managing money.  Alas, that is the situation today.

Watching the Clock

So, what happens if August 2 rolls around and there is no deal to raise the debt limit?  A lot will depend on what political leaders are saying at that point.

Up to this point, Republicans are holding firm to their belief that a debt ceiling increase has to be met dollar-for-dollar with spending cuts while Democrats are insisting any deficit reduction plan has to include revenue increases (i.e. tax increases that Republicans won't accept). 

President Obama indicated in a July 11 press conference that he will not sign any deal that produces only a short-term extension of the debt limit (i.e. an extension that expires before the 2012 election).  He also declared a deal will get done by August 2. 

The White House reportedly tried to orchestrate a budget retreat at Camp David this weekend, yet Congressional leaders from both parties (i.e. Boehner and Pelosi) shot down the idea.  It was striking that Pelosi did so, almost mocking the idea at a news conference and underscoring in the process that the president faces opposition not only from the Republicans but within his own party as well now that he has offered up entitlement reform as a bargaining chip.

There are a lot of moving parts (and mouths) right now that are making the idea of a compromise before August 2 a dicey proposition.

We wish we had a crystal ball to tell us exactly what will happen.  We don't and neither does anybody else. 

We are leaning toward the idea of an eleventh-hour solution, although one of our biggest concerns at the moment is that that view is held by most market participants and that there is a sense of complacency on the matter because of it. 

If the eleventh hour comes and goes without a compromise and ideological views remain entrenched, a lot of people are going to be shocked and it could be an ugly ordeal, certainly in the short-term, for the capital markets and even more so if principal and interest payments on U.S. debt are missed for an extended period of time.

As alluded to above, an ugly reaction could be a catalyst for a compromise to be reached that, in turn, limits any fallout.  There again, though, we just don't know.  We will have to assess the tone at that time and evaluate if any lasting damage has been done that cuts into earnings prospects.

The uncertainty on this matter is a reason why large-cap, multinational companies with healthy balance sheets, secure dividends, and ample liquidity should hold added appeal for investors putting money to work at this time. 

Estranged Bedfellows

Politics, it is said, makes strange bedfellows.  Well, the lights are low now, and while no one is asking the Republicans and Democrats to spoon under the covers, it would be nice if they could at least slide into opposite sides of the bed together. 

Moody's for one is worried that they will choose to remain estranged bedfellows and has placed the U.S. debt rating on review for a possible downgrade.  In doing so, the ratings agency added that there was no assurance it would restore a AAA rating, should it be downgraded, even if a default was quickly cured. Separately, Standard and Poor's has intimated that it will be inclined to cut the debt rating if the debt ceiling is raised but there isn't bi-partisan agreement for a meaningful cut in the deficit. 

The Moody's viewpoint in particular captures the concerns of many pundits who worry that permanent, reputational damage will be done to the U.S. if it demonstrates, even for a short while, that the full faith and credit of the U.S. government is now a punch line rather than a line that packs indisputable punch.

Let's all hope the ideological views of our political leaders don't allow logically idiotic results to ensue.

--Patrick J. O'Hare, Briefing.com

Patrick J. O'Hare is the Chief Market Analyst for Briefing Research, Briefing.com's institutional research service. To request a free trial please email researchsales@briefing.com.