There are two gigantic economic crises weighing heavily on the minds of investors and government leaders right now: the raising of the debt ceiling and the risk to the country’s venerable AAA sovereign debt rating.

Politicians, economists and media types across the sociopolitical landscape have weighed in with dire prognostications about what could or would happen if Congress and the White House fail to broker a deal to raise the debt ceiling by Aug. 2.

For investors, homeowners, businesses -- large and small -- and retirees, an even bigger source of angst is the uncertainty surrounding if, how and when the government plans to find $4 trillion in budget cuts over the next 10 years.

If it doesn't, some pundits suggest, Standard & Poor's might actually follow through on its threat to lower the country’s debt rating to AA and further erode the chance of a rebound in the U.S. economy.

But at least one analyst, UBS strategist Katherine Klingensmith, told On Wall Street that both of these supposed "doomsday" scenarios are overblown.

“First of all, most of the economists and analysts on Wall Street remain confident that a deal will be reached to raise the ceiling before the deadline," Klingensmith said. But she added, even if that day arrives without a deal, “I’m not sure that that Aug. 2 date is really a hard deadline.”

She notes that the government has actually borrowed up to the debt ceiling already since the middle of June, “and the Treasury has been avoiding exceeding it by making accounting changes -- for example halting making payments to certain federal pension funds and by credit swaps between different departments.  They may be able to continue to do that kind of thing for a while past August 2.” 

She said there are several hard dates coming up, each of which would be successively harder to finesse: the Aug. 3 date when the monthly Social Security checks are due to go out; Aug. 5, when a T-bill auction is scheduled, and Aug. 15, when the next interest payment on the federal debt comes due.

Klingensmith, who earlier in her career spent some time working at the Federal Reserve, said the Fed “has the ability to indirectly intervene in the market to prevent a Treasury auction from failing,” and that it could also take actions to help prevent a default. 

The Treasury Department, she said, could also act to prioritize payments instead of paying them all as they come due. 

Finally, lawyers are reportedly looking at whether the president has the authority to unilaterally act to continue borrowing and paying the government’s bills, ignoring the deficit ceiling.

Noting that equities markets and the Treasury market have remained relatively calm, considering all the noise in the news about a possible default, Klingensmith said both markets appear to be assuming a deal will come.

If the deadline passes without a deal, though, she predicts markets could get “a bit chaotic” and that there would be a big move by investors into risk havens like gold. “But we wouldn’t have an economic collapse," she said.

She said right now it is clear to most investors, both at home and abroad, that the crisis facing the country is political, not economic, and that any default would be temporary. 

“This is not Argentina,” she said. “So it would be ugly, but people know they would be made whole when the crisis is finally solved.”

To support this contention, she pointed out that the price of default swaps on U.S. debt, which are used by investors to insure against a default, is higher for one year than for five years -- a very unusual pricing situation. “This means that people know that the crisis is political, not structural,” she said.

As for the growing likelihood of a downgrade in the U.S. sovereign rating, she again notes that while serious, this too would not be a disaster.

“Of course, it’s not the same as Japan, which already was downgraded from AAA to AA,” she said. "Japanese debt is almost entirely held by Japanese investors, while half of U.S. debt is held overseas. We can’t know for sure how foreign holders would react to a downgrade, although there is a question of where else they can go.” 

Besides, she added, the difference in AAA and AA in terms of a bank’s capital requirements is not much.

“Central banks, pension funds and long-term managers have these rules about needing to have a certain percentage of 0% risk holdings in their portfolios,” she said, “but these rules are of their own making. It could be that if the U.S. rating fell to AA, they might have to rewrite their rules.”  But then again, she added, “It’s only S&P that has said it may lower the rating. Moody's and Fitch have not said that. So you could have the U.S. end up with a mixed rating and many banks and other organizations could probably accept that without having to engage in any forced selling of Treasuries.”

The bottom line: We’re in “uncharted territory,” but the rhetoric about economic collapse, according to Klingensmith, is probably overblown.

However, that doesn't mean she's completely unconcerned about the ongoing debt-ceiling fiasco.

“If they did end up passing a big budget cut deal, with a lot of the cuts early on, we could see it really hurt the economy and the national debt could actually rise because the government would end up collecting much less revenue," she said.

Klingensmith points to a similar situation two years ago when the UK government also faced a threat to its debt rating and responded by making major budget cuts that sent its economy into a double-dip recession.

“It’s hard to say how much of the economy in the U.S. depends upon federal spending,” said Klingensmith.










Register or login for access to this item and much more

All On Wall Street content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access