(Kitco News) - The stalemate between Democrats and Republicans regarding a vote to lift the U.S. debt ceiling is giving gold a boost, and if an agreement is not reached before the Aug. 2 deadline, many market watchers believe there would be a rush to buy gold and other hard assets.

That said, many people believe that the two sides will come to an agreement that will allow the current $14.3 trillion debt ceiling to be lifted and the U.S. will not enter into a technical default.

The impasse essentially boils down to that Republicans want more spending cuts and no tax increases, while Democrats want a combination of spending cuts and increased revenue, before either side will vote on legislation. The Treasury Department has said by Aug. 2, the U.S. will run out of funds to pay for all its U.S. obligations. The Washington Post reported that the White House has said an agreement must be made by July 22 to leave enough time to approve the legislation to lift the debt ceiling.

Jim Steel, senior vice president and metals analyst with HSBC, said that an actual default is unlikely. “What’s more important is that the negotiations have dragged on this long,” he said.

The bickering between the Democrats and Republicans over raising the debt ceiling has been bullish for gold, he said. If a resolution is reached in time, as is expected by most people, then gold could pull back, he said. But how much is unclear because the debt-ceiling talks are just one factor that is supporting gold.

“I really want to emphasis that I don’t think it (default) is going to happen. But this is intertwined with the situation in Europe, the possibility for further stimulus in the U.S., higher inflation in China. It’s almost impossible to deconstruct (how much support) each issue has. They’re all supportive,” Steel said.

Even if the debt ceiling is not raised, the U.S. would have money coming in to pay some obligations, but it would have to make choices on who gets paid and who doesn’t. That’s why it is considered a technical default.

Barclays Capital analysts said first in line would be bond holders. “While Treasury has said that it does not want to pick and choose which payments to make and which not to (if the debt ceiling is not raised), we continue to believe that if absolutely necessary, the U.S. will prioritize coupon payments over other outlays,” the bank said.

Late Wednesday, Moody's Investors Service said it placed the U.S.’s Aaa bond rating “on review” given the rising possibility that the debt limit will not be raised in time.

That news pushed gold prices to new highs, and it came on the heels of comments by Federal Reserve Chairman Ben Bernanke’s to Congress that the Fed has “untested means” to stimulate the U.S. economy if needed, but he said Thursday the Fed wasn’t ready to take immediate action.

Moody’s said it “considers the probability of a default on interest payments to be low but no longer to be de minimis…. However, because this type of default is expected to be short-lived, and the expected loss to holders of Treasury bonds would be minimal or non-existent, the rating would most likely be downgraded to somewhere in the Aa range.”

Some have said that if a default happens, then Treasury yields would rise. Normally higher interest rates are bearish for gold. But guessing what may happen and knowing how it would play out are two different scenarios.

“It’s very difficult to say. Higher yields are bearish and yet a technical default would be bullish. We have no history to judge how gold would react. This has never happened before,” Steel said.

Steel said this issue is something that must be watched day to day, as the situation is fluid.

Michael Wallace, global market strategist at Action Economics, said the initial reaction by the markets to no debt-ceiling deal would be similar to how the markets reacted to the Moody’s announcement: higher gold, higher Treasury yields, lower dollar and stock market.

He said the initial reaction by the bond market is a 25- to 50-basis-point spike in long-dated Treasury yields, like 10-year notes and 30-year bonds. The short end of the curve probably wouldn’t react. That would make the yield curve steepen, which normally suggests a growing economy.

“This time, though, what that would signal is a credit event,” Wallace said.

It would be particularly harmful because the Fed has been trying to keep the long end of the yield curve down through its quantitative easing programs and other stimulus.

After the initial spike and likely political fallout, yields could drift back down, Wallace said, but would be unlikely to completely erase the spike. Currently, 10-year-note yields are around 2.91% - he wouldn’t expect to see those yields under 3% if they would jump on a technical default.

Mike Daly, gold and silver specialist at PFGBest, said if a technical default were to happen, he would expected gold prices “to go through the roof.”

“The largest economy in the world can’t pay its bills, it makes the whole world look bad,” Daly said.

If it were to happen, he’d expect gold to go to $1,700 an ounce in short order. On Thursday, August gold futures on the Comex division of the New York Mercantile Exchange were trading around $1,585.

NOT EVERYONE EXPECTS SHARP MARKET REACTIONS

Ed Grebeck, chief executive officer of Tempus Advisors and a veteran of the bond markets, said he thinks the markets are more concerned about the longer-term health of the U.S. economy, rather than the short-term fix of raising the debt ceiling. Even if the U.S. went a few days beyond the deadline, he doesn’t think the markets would react.  

“Provided it did not go more than a couple of days, I don’t think there would be any market reaction at all. I think they fear the consequences of the U.S. government kicking the can down the road,” he said.

He is also dismissive of the credit ratings agencies’ warnings, given the past history of missing problems.

The situation for gold is bullish either way, Grebeck said. A technical default would push people to gold, and a stop-gap settlement would mean a temporary fix to the economic issues.

Michael Szenberg, distinguished professor of economics at Pace University’s Lubin School of Business, said he believes that yields would likely spike under a default situation, but he and Grebeck point out the rise is relative, noting that in the 1970s and early 1980s, bond yields were hovering around 20%. “The American economy is dealing with tremendous fragility, but this (debate) might take us in the direction we need to go,” Szenberg said.

Grebeck said the only negative for gold would be if politicians were to come together and address the the long-term structural problems in the economy.

“People are concerned how the U.S. government and all governments around the world deal with money in the future,” he said.  “The takeaway of this is we might be at the beginning of the end of fiat currency.”

By Debbie Carlson of Kitco News dcarlson@kitco.com

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