US Debt Mountain

The debt ceiling doesn't matter.  What matters is how much new Treasury debt is being issued each year.  The budget deficit since 2009 has gotten to such large levels that you are getting a huge increase in US Treasury supply.  Everything is determined by supply and demand.  With demand staying equal, an increase in supply can only do one thing: decrease the price.  The pace of Treasury supply increases has gone parabolic.  These are truly historic budget deficits that the US has never seen before in its history, even inflation adjusted. 

From 2009 to 2011, approximately 4 Trillion in new Treasuries will have/had to be issued due to the budget deficits.  Fed's QE through expanding its balance sheet by nearly 2 Trillion has taken out almost half of the supply either directly (direct Treasury purchases) or indirectly by displacing MBS holders (MBS purchases) pushing them into other debt/investments.  That is how long term Treasury rates have been kept artificially low.  Add to that, the fear of the average investor who has fled stocks for the "safer" waters of bonds has boosted demand along with the Fed purchases.  Bond inflows have been massive since 2008 and this strong fund inflow has helped to keep rates low.  But we all know that the average investor chases performance, and bonds have been performing strongly over the past 30 years.  What if that performance fades in the face of pressures of new Treasury supply?

I see 2 scenarios here.  First scenario with QE3 and the second scenario without QE3.  With QE3, more Treasuries will be purchased, sopping up much of the extra Treasury supply coming from the huge budget deficit.  This will help keep long term rates low but I guarantee you that investors will stampede out of the dollar.  There will be extreme dollar weakness, similar to what you saw in the first half of 2008.  Gold and silver will go through the roof.  Equities will also benefit somewhat from the extra money printing.  This is the most likely scenario which is why I am so bullish on precious metals.  It has nothing to do with the debt ceiling or the European sovereign debt crisis.

Under the other scenario without QE3 (very unlikely), the economy will have been relatively stable (otherwise there would be a QE3) leading to bond weakness, which with the big increase in the Treasury supply would lead to a bond market rout.  Long rates would shoot higher and bond fund outflows would only exacerbate the move.  The dollar would be weak, but stable.  Equities will struggle under this scenario because of the threat of higher interest rates and tighter money. 

There is no scenario where I see deflation or a significant reduction of the budget deficit.  The U.S.  has taken the road of Keynes and tried to spend their way out of their problems.  Europe has taken the road of austerity reducing spending.  That is why you are seeing such weakness in European equities compared to the U.S.  In the short run, austerity will hurt equities and spending helps equities.  In the long run, in currency adjusted terms, the opposite effect will occur, all things being equal. 

Year

Nominal Dollars

Inflation Adjusted

2002

157.8 Billion Dollar Deficit

186.204 Billion Deficit

2003

374 Billion Dollar Deficit

430.1 Billion Deficit

2004

413 Billion Dollar Deficit

462.56 Billion Deficit

2005

319 Billion Dollar Deficit

347.71 Billion Deficit

2006

248 Billion Dollar Deficit

260.4 Billion Deficit

2007

162 Billion Dollar Deficit

165.24 Billion Deficit

2008

455 Billion Dollar Deficit

455 Billion Deficit

2009

1416 Billion Dollar Deficit

1416 Billion Deficit

2010

1294 Billion Dollar Deficit

1294 Billion Deficit

2011

1650 Billion Dollar Deficit

1650 Billion Deficit