The Commodity Investor explains the US debt ceiling and provides insight on how it could impact the economy and, more specifically, commodities.
For the second time in less than two years, the United States is facing a debt-ceiling calamity. In this installment of The Commodity Investor, we will discuss the debt ceiling and then examine what impact, if any, it will have on commodity markets.
The debt ceiling explained
The US, just like any other country in the world, issues debt in order to finance its existing operations and meet its current legal obligations. These legal obligations include paying back holders of its debt (in the form of bonds issued by the treasury department), paying for services such as Social Security and Medicaid, issuing tax refunds, paying government employee salaries and more.
The debt that the US issues via the treasury department is vital for both the operation of the government and the country — indeed, without this borrowing, the US as we know it would not exist. Firefighters wouldn’t have the proper equipment or resources to fight fires, public hospitals would shut down, the US military machine would come to a grinding halt and the state department wouldn’t be able to issue new passports; in short, the list of government services that would shut down is endless.
That doesn’t even begin to describe the damage that would be done to the US economy. As of now, US sovereign debt is considered the safest investment in the world. Nations such as China, Japan, Saudi Arabia and others with large reserves prefer to invest their excess liquidity in American national debt and see it as the most secure investment. That is because in decades the US treasury has never defaulted on its obligations. However, this confidence would go up in smoke if the US treasury failed to pay its obligations to international bondholders.
At the moment, the government’s borrowing capability stands at $16.4 trillion. In order to meet its existing legal obligations, Congress needs to raise the government’s ability to borrow — in other words, raise the debt ceiling. If this capability is not raised, the government will not be able to meet certain of its existing obligations and will essentially have to default on its debt. That would be catastrophic as it would cause economic chaos not only within the US, but also in the global financial market.
The debt ceiling and commodities
If Congress fails to increase the federal debt limit, not only will America’s credibility in the global markets take a near-fatal hit, but the US economy itself will be thrown into an uncontrollable tailspin that will impact global economic growth. Global economic growth is the engine that drives demand for natural resources and is the main impetus for commodity price increases. A US debt default would do long-lasting economic damage to the global economy. One immediate impact of such a scenario would be drastically reduced demand for natural resources, especially industrial commodities such as crude oil, copper, iron ore and natural gas.
Since the US is the largest economy in the world, any confidence-reducing event is guaranteed to have a widespread impact on the global economy. Therefore, a US default would be disastrous for commodities across the board. The only potential exception within the commodities complex is gold, which might actually benefit from a US default.
For decades, currencies such as the US dollar have been backed by gold — gold, in fact, was the global default currency for decades. After President Nixon took the US off the gold standard, the global reserve currency became the US dollar. However, if the US can’t service its debt, that will cause irreparable harm to the greenback as the world’s reserve currency. In this environment, there is a strong likelihood that investors will flock back to gold as the ultimate safe-haven asset.
During the 2008 crisis, US treasuries acted as a safe-haven asset; but what if US treasuries are no longer deemed safe by international investors? If that happens, gold will act once again as the world’s reserve currency and will attract significant demand from panicked investors. If the US debt ceiling isn’t resolved, look for gold to be one of the best-performing potential investments. Investors are recommended to own either physical gold or the main gold ETFs.
Securities Disclosure: I, Amine Bouchentouf, hold no positions in the stocks mentioned.
Columnist Amine Bouchentouf is a partner at Parador Capital LLC, an institutional advisory firm focused on commodities and emerging markets. He is the author of the bestselling Commodities For Dummies, published by Wiley. Amine is also the founder of Commodities Investors LLC, an advisory firm dedicated to providing insightful information on all things commodities.