Bernanke Wants More Debt to Get Less Debt

The Chairman of the Federal Reserve, Ben Bernanke, gave a speech on Tuesday, in which he urged congressional leaders to tackle the long-term fiscal imbalances of the United States without failing to raise the debt ceiling.

Bernanke argued that the deficit should decrease naturally as the economy expands and employment returns to normal levels. Yet, he stated that the long-term problems of the U.S.'s present fiscal imbalances would be severe if not acted upon.

Bernanke stated that as debt levels increased the economy would become more susceptible to fiscal shocks, and a crowding-out effect—wherein invested capital goes to the government rather than the private sector—would stifle economic growth.

Interest rates could rise rapidly, as the economic troubles in Europe have demonstrated, Bernanke explained. It is impossible to accurately predict the moment when the bond market would decide to abandon a country's debt, but Bernanke stated that each day the U.S. does not get its fiscal house in order is one day closer to that scenario playing out.

Bernanke bluntly stated that the status quo was impossible to maintain. The U.S. should, as quickly as possible, create a long-term plan to reduce fiscal imbalances.

Further, any plan created must be a credible one. Bernanke suggested implementing a legal GDP-to-debt ratio and working to reduce that ratio over time.

Still, Bernanke was emphatic in his displeasure with those using the debt ceiling to push for fiscal cuts.

Bernanke stated that if the debt ceiling is not reached before the August deadline, there would be severe financial consequences. Interest rates could immediately spike, which would make it more difficult for the U.S. to make interest payments, further slowing recovery.

Some have suggested a solution wherein the debt ceiling would not be raised, but government payments would be appropriated to bond holders while other payments would be delayed. Bernanke dismissed this argument, stating that it would decrease overall confidence in U.S. debt.

Action Items

Bullish: Traders who believe that Congress will follow Bernanke's advice and raise the debt ceiling while reducing long-term fiscal budget deficits might want to consider the following trades:

• Buy Power Shares DB US Dollar Bullish Index (NYSE: UUP) in a long dollar play. The dollar has been under selling pressure, but might rally if the U.S. is able to constrain its long-term budget.
• Buy iShares Lehman Aggregate Bond (NYSE: AGG) in a long play on U.S. bonds. If the U.S debt situation becomes more attractive, the U.S. bond market might rally.

Bearish: Traders who believe that the U.S. will default, or otherwise fail to reduce its long-term budget deficits may consider taking positions in the following:

• SPDR Gold Trust (NYSE: GLD) is a long play on the precious metal gold. Gold has appreciated in price significantly over the past several months, and may head higher if the U.S. is unable to get its deficits under control, as investors seek to dump their paper currency for the safe-haven of gold.
• Market Vectors Junior Gold Miners (NYSE: GDXJ) is a more aggressive play on gold. If the metal is rallying, GDXJ might rally even more.

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