In the most recent quarterly commentary, I noted that the vote on raising the debt ceiling could begin as soon as this past weekend. Unfortunately, that didn’t happen. Instead, talks between the House of Representatives and the White House broke off on Thursday evening. That’s unfortunate, as the deal they were discussing purportedly targeted deficit reduction of nearly $4 trillion over the next decade and included a number of positives, including new revenues and expense reduction in entitlement spending. Each side had to give a bit, but by targeting revenues and expenses, neither would have to be drastically changed.

Ultimately, Speaker Boehner explained that he walked away from the deal because he couldn’t abide a White House request to raise targeted revenues from $800 billion to $1.2 trillion. Subsequent talks between congressional leaders yielded little progress and as a result, both the House and the Senate are pursuing their own bills. Boehner has indicated that he will pursue an increase that requires two steps and two votes – one now and one in 6 months. This strikes us as a bad idea for the economy. To understand why at the most basic level, imagine lending money to someone who tells you that he’ll honor his debt to you now and may continue to do so in 6 months, but he’ll get back to you on that one.

Odds remain high that Congress will ultimately present a bill to President Obama to raise the debt ceiling. However, even absent default, we can’t help but wonder if some damage has already been done. While the debt ceiling increase has been subject to protest votes before, we can’t recall a time in which the increase itself was subject to such legislative wrangling. Further, the idea that over 80 members of the House Tea Party caucus would sign a letter stating flatly they would not vote to increase the limit – in effect stating that they would not honor the government’s financial obligations – is something that to our knowledge has never been done before. Finally, the ratings agencies have indicated that absent a long -term agreement encompassing deficit reduction of a minimum of $3 trillion, a downgrade is a real possibility. With the so-called grand bargain now off the table, it’s unlikely a deal will be forthcoming offering that level of cuts.

The upshot of the foregoing is that we still think it very likely the debt ceiling will be raised, but without a bill that offers greater reduction than now being discussed it seems a downgrade is quite possible. Given that the economy is already facing a faltering recovery, higher interest costs could very well force us back into recession and any immediate austerity as a result of the deal would worsen the situation. Based on these downside risks, we continue to position portfolios defensively, and as we outlined in the commentary, most bond funds have greatly reduced exposure to treasuries.

As to the debt ceiling talks, given the legislative calendar, the House will have to approve legislation this week in order for a bill to ultimately reach the President’s desk by the August 2nd deadline. Thus, we should know in the next few days if the debt ceiling will be raised and what form the ultimate solution will likely take. We will send out more of our thoughts on the topic in the coming week.