US Debt Ceiling and its Impact on FX and Stock Markets

The US Federal Government spent more than it earned virtually from its inception.  The first recorded deficit budget that had to be financed by a loan was that of January 1791.

Since then, government spending has consistently been more than government income, although there were relatively short periods during which income exceeded expenditure. 

When the government spends more than it earns, it has to borrow the difference.  In the US, this is done through the issue of Treasury Bills.  Since the 1960s, the percentage of US Treasury Bills held by foreign countries has been steadily increasing.  At the moment the biggest buyers of US Treasury Bills are China, Japan, and the United Kingdom.

Ceiling

Article 1 Section 8 of the US Constitution has put Congress in charge of managing public debt.  Initially Congress had to authorise every issue of Treasury bills separately, but in 1917 it decided to simply implement a debt ceiling.  As long as Government debt does not exceed this limit, approval from Congress is not necessary.

US Government Debt Crisis

Over the years US deficit spending, often as the result of wars such as the American Civil War, WWI, WW2 and lately the invasion of Iraq and Afghanistan, has steadily pushed up the level of Government debt in that country.

When this debt level reaches a point where it approaches the debt ceiling, Congress has to authorise an increase in the ceiling.  President Obama is now ( July 2011) asking for a $2 trillion increase in this ceiling, which will only be sufficient to ensure the US Government can keep on functioning until the end of 2012.

When the politicians controlling the US Congress cannot come to a decision about increasing the debt ceiling, it raises the risk of the US Government being unable to meet its obligations.  In this case, welfare payments or other Government programmes might have to be stopped.

Short Term Effects on FX and Stock Markets

When the US Government ends up in a position where its lending approaches the debt ceiling, it can only roll over existing debt – it cannot issue new Treasury bills.  What happens next is usually that the demand for these bills exceeds supply, causing interest rates on them to drop.  

As government expenditure comes closer to the debt ceiling, and fears of an impasse start to grow more intense, the stock markets are often negatively affected – unless there are of course other factors working in mitigation of this.

Such a situation also puts downward pressure on the US dollar, which could once again be mitigated by other factors.

Relief

Once the politicians agree on increasing the debt ceiling, the stock markets and USD FX markets normally react favourably – even though this might be short-lived.  Interest rates on Treasury bills usually start increasing again.

Exploiting the Situation

An astute trader could cash in on this situation by going long on the USD or a stock index such as the S&P 500 before an agreement on the debt ceiling is reached.  There are, however, risks involved: A prolonged stalemate could have unforeseen consequences that might send markets into a downward spiral from which they could only emerge after a prolonged period of time.

Spread betting and CFD trading carry a high level of risk and you can lose more than your initial deposit so you should ensure these trading products meet your investment objectives and if necessary seek independent advice.