US government debt is generally considered to be among the safest in the world. Despite a budget deficit around 10% of GDP, and a debt to GDP ratio of near 100%, government bond yields remain near historical lows. This reflects the market expectation that the debt is very safe, despite the poor economic fundamentals.
So it probably comes as a surprise that the largest rating agencies have put the US on a potential downgrade watch. They are saying that there is 50% probability that the US credit rating will be downgraded in the next three months. All of this is due to a legal issue surrounding the maximum total amount of debt.
The US currently has a debt ceiling (i.e. total debt cannot rise beyond this level) of around $14.3 trillion. The congress must pass a law increasing this debt ceiling in order for the government to continue to borrow money and fund its deficit. The US will hit its debt limit by August 2nd, and if the ceiling is not raised, the government will run out of money.
A US default would be quite catastrophic for global financial stability. To put this into perspective, consider Greece that has been near default for some time. The Greek debt crisis has had a large negative impact on markets and the global economy, and they haven't actually defaulted yet! By contrast, the US economy is approximately 44 times larger than the Greek economy. Clearly the impact of default would be much greater.
The big difference between Greece and the US is that Greece had no choice but to receive a bailout to avoid default. Their bond yields had risen so much, that it was not possible for them to borrow from investors to fund their deficit. On the other hand, if the US defaults, it will have been by choice.
As mentioned, the bond market is perfectly content in lending to the US government at record low interest rates. The real problem is with the politicians, who are unable to agree to raise the debt ceiling. While the long-term increasing debt of the US is certainly an issue that needs to be fixed, it's a no brainer that in the short term, the debt ceiling needs to be raised, given the potential consequences of a US default.
The fact that the US may default due to a malfunctioning political system rather than a serious economic problem is really cause for concern. It reaffirms the view of most people - that politicians are incompetent and they usually cause more harm than good.
After all, most of the debt problems around the world are caused by politicians in the first place, who happily spend more money without paying for it, in order to increase their chances of getting reelected. So now, the fate of the US economy and the fate of the global financial system are in the hands of a few hundred incompetent people. Get ready for: 'The Global Financial Crisis - Part II' (the sequel).
Disclosure: I do not hold the currency/commodity that is analyzed in this column.
Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!