What do we need to know about the debt-ceiling situation?

By Dirk Hofschire, CFA, Vice President, Fidelity Asset Allocation Research.

The debt ceiling is essentially a self-imposed, near-term deadline on a very serious medium-term fiscal problem. In this respect, the debt-ceiling situation is something of an artificial, or self-made, crisis. Congress passed a law that limits how much the U.S. can borrow, but it can pass another one raising that amount (as it has several times before). The near-term concern among investors in the global financial markets is not about America’s ability to service its debt—it is about its willingness to do so.

The good news about the artificial or self-made nature of this situation is that it can be quickly remedied if policymakers decide to willingly continue servicing the debt. If you contrast this with Greece, for instance, the problem for the U.S. is much more manageable. Currently, yields on two-year Greek government bonds are around 25%, reflecting that investors are concerned that Greek debt levels are unsustainable. The U.S. government, in contrast, can issue 10-year bonds at just 3%, implying the U.S. is having no trouble financing its near-term obligations—as long as it chooses to continue to do so.

The unfortunate part of the situation is that there may be some risk to financial markets if a final resolution is delayed due to the polarized debate in Washington. Uncertainty creates volatility, which translates into larger price fluctuations in the financial markets.

As we approach the August 2 deadline without a legislative agreement, volatility will continue to increase. However, once there is a resolution of the situation and the debt ceiling is raised, the markets are likely to reverse course and benefit from a relief rally. The more acute the sell off and volatility leading up to the deadline, the more likely policymakers will feel urgency to resolve the issue, making a market reversal even more likely.

This potential volatility makes it very difficult as an investor to take any action, which means one should tread carefully before trying to make tactical decisions based solely on the near-term outlook for the debt-ceiling situation.