A Toothless Debt Deal Won’t Stop a U.S. Credit-Rating Downgrade – Or the Aftermath that Follows

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It's often said that the sign of a good compromise is that both parties walk away dissatisfied – but that's not necessarily true of the debt deal Congress is close to passing.

To be sure, both parties are dissatisfied with the outcome of this contentious battle. Progressive Democrats are disappointed that planned cuts to government spending won't be augmented with tax increases, while fiscally conservative Republicans are angry that the cuts to spending haven't gone far enough.

But the truth is, regardless of their party allegiances, all Americans should be disappointed in their policymakers for the same exact reason: After months of political kabuki theater, the debt deal that's working its way through Congress is toothless, ineffectual and will do little or nothing to prevent a crushing blow to the markets and the dollar.

The facts of the debt deal are as follows:

  • The deal raises the debt ceiling by $900 billion to $17.7 trillion.
  • It cuts spending by $917 billion over the next decade and a special congressional committee will be assigned to find another $1.5 trillion in deficit savings by late November.
  • If Congress comes up with the savings, or passes a balanced-budget amendment to the constitution, the government will accrue another $1.5 trillion boost the debt ceiling – sufficient to pay the country's bills through 2013.
  • If Congress fails, the president will be granted a $1.2 trillion debt-ceiling extension – but automatic, government-wide spending cuts (half of which will come from the defense budget) will take effect in 2013. There will be no automatic tax increases.

The United States at least may have will have avoided default, but the country is still enrapt in debt and likely to incur a credit-rating downgrade.

"The deal does not put the U.S. fiscal position on a sustainable path and will not prevent the U.S. from losing its AAA credit rating," Paul Dales, senior U.S. economist at Capital Economics, told MarketWatch. "The only question is whether S&P and the other rating agencies pull the trigger this week or wait a little longer."

Standard & Poor's has taken the hardest line, but both Moody's Corp. (NYSE: MCO) and Fitch Ratings Inc. have signalled that they too are prepared to slash their ratings on U.S. credit.

S&P last week suggested that it would require a deficit-reduction agreement of around $4 trillion, along with convincing signs that it could be enforced, to affirm its AAA rating on the United States. The ratings agency in April downgraded its outlook for U.S. debt to "negative," from "stable."

Moody's Investment Service issued a warning last month, as well, saying the United States would have to deal with its debt problem – regardless of whether or not a compromise was reached on the debt ceiling.

"The outlook assigned at that time to the government bond rating would very likely be changed to negative at the conclusion of the review unless substantial and credible agreement is achieved on a budget that includes long-term deficit reduction," Moody's said.

The Unanticipated Aftermath of a U.S. Credit Downgrade

In the best-case scenario, a lower credit rating simply means the government will have to pay higher borrowing costs. And if that's the case, every American should consider themselves lucky, because the alternative scenarios paint a much darker picture.

"After studying everything that could happen due to a downgrade of the United States' top-tier AAA credit rating, and the potential default on its debt, we found a scenario that would result in forced asset sales that are so widespread that global stock-and-bond markets would plunge – and economies around the world would crash," said Money Morning Contributing Editor Shah Gilani.

As premise for his argument, Gilani points to the fact that U.S. Treasury bills, notes, and bonds currently are considered "risk-free." But if that ceases to be the case, financial firms will have to recalculate their net capital positions to accommodate the added risk.

Worse, many of those firms have already leveraged their Treasury securities to borrow more money to buy more government bonds and other – more-speculative – investments. So if these firms are made to take a serious "haircut" on federal debt obligations, their lenders could demand additional security on the loans they've made.

"This could actually result in a kind of ‘global margin call' – kicking off a worldwide de-leveraging scenario that could sink global markets and torpedo world economies," said Gilani.

Equally disconcerting, is that the fate of the dollar is intrinsically connected to Treasuries, which means the greenback itself could be in line for a bulldozing.

"The dollar is also almost certain to drop if the vast U.S. budget deficit causes a crisis in the Treasury bond market," said Money Morning Contributing Editor Martin Hutchinson.

According to Hutchinson, the dollar has already been done in by Federal Reserve Chairman Ben S. Bernanke's expansive monetary policy and increasingly competitive emerging economies. But a credit rating downgrade will be the final nail in the greenback's coffin.

How to Protect Yourself from a Debt-Rating Downgrade

The U.S. economy may be in for a rude awakening, but there are steps you can take to prepare yourself and preserve your wealth.

To begin with, you may consider the Rydex Inverse Government Long Bond Strategy Fund (NYSE: RYJUX), which will rise as long-term Treasury bonds lose their value.

Secondly, to preserve your wealth against the dollar's inexorable decline you could simply invest in gold via the SPDR Gold Trust ETF (NYSE: GLD). Gold prices dipped yesterday on the news of a debt deal, but rebounded as soon as investors realized no real progress had been made on U.S. debt. The long-term trajectory for gold prices is upward.

Additionally, Martin Hutchinson recently outlined four currency investments that could help you benefit from the dollar's demise.

  • The Swiss franc: Switzerland is the ideal European country – chiefly because it has a large-but-safe banking system. The Swiss National Bank made UBS AG (NYSE: UBS) and Credit Suisse Group AG (NYSE ADR: CS) recapitalize themselves properly and have forced the two to do more wealth management and less investment banking.
  • The Norwegian crown: Norway has oil, a large trust fund and no European Union membership. That trust fund (actually a very-well-managed, $570 billion sovereign wealth fund) makes this one ideal – even if oil prices collapse.
  • The Singapore dollar: This is a beautifully run country – the least corrupt in the world, in fact – and is a banking-and-trading entrepôt, to boot.
  • The Chilean peso: Chile is less corrupt than the United States. It has a commodity economy, but is better run than Australia (and less likely to be under cut by cheaper labor, since Chilean labor is still quite cheap). And it has a trust fund (sovereign wealth fund) to guard against a return of low commodity prices.

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  1. Gary from OZ | August 2, 2011

    What are your thoughts on the Aussie Dollar?

  2. come-and-take-it | August 4, 2011

    So many ways for things to go wrong and so few that will make them right. The problem is noone is willing to sign up for the shearing we will all suffer regardless of socio-economic status to make this thing right. If we all agreed to shoulder our own part of the burden (no more handouts/tax loopholes) and a formula was developed that made sense, I think the majority of Americans would buy-in for the good of the country and their grandkids. Try dividing the debt by the total net worth of every taxpayer in the country. Once it's paid down, no more government entitlement programs that have not or are not being funded. We have to think outside the box here or we are all going to take a bite of a huge Schumerburger.

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