StanCollender'sCapitalGainsandGames Washington, Wall Street and Everything in Between



Wall Street Is Already Reacting Negatively To Debt Ceiling Fight

07 Jun 2011
Posted by Stan Collender

Contrary to what the GOP has been saying, financial markets not only will react negatively to the debt ceiling fight happening on Capital Hill, but as I explain in my column from today's Roll Call, that negative reaction has already begun and it's not at all ambiguous or tepid.

 

 Negative Market Reaction to Debt Ceiling Fight

Three things are wrong with the continuing insistence by the Republican Congressional leadership and a number of potential GOP presidential candidates that the financial markets will not react negatively if the existing federal debt ceiling is not increased by Aug. 2, the date that the U.S. Treasury says the government’s cash situation will become critical.

First, it’s not at all clear that GOP Congressional leaders really believe what they are saying. One of the back stories to last week’s scam of a debate in the House on a “clean” debt ceiling bill was that the leadership apparently went out of its way to let the financial world know in advance that the vote was nothing more than political theater and shouldn’t be taken seriously. That’s the Washington version of the hedging that’s typical on Wall Street. It’s also ample evidence that the leadership was worried enough about a negative reaction from investors that it needed to reassure them in advance about what was happening and what it meant. That’s not a vote of confidence in the hold-the-debt-ceiling-hostage strategy that we keep being told will not have a negative impact on interest rates, market psychology, stock prices or economic growth.

Second, the leadership and the candidates don’t seem to realize or be able to admit that the White House is in control of many of the levers that will affect the markets. Administration officials, not the Congressional leadership, will determine how to deal with a cash shortage, and Wall Street is much more likely to react to the Treasury’s decisions than to political hyperbole, demagoguery and attempted spin. Try to imagine the virtually immediate impact on the stock price of government contractors if the administration announces on Aug. 2 that money owed to those companies will be paid after 120 days instead of 30, and you start to get a sense of how much the White House rather than Congressional Republicans are in control of the situation.

Third, in spite of all the GOP protestations to the contrary, there are actually a number of important signs that capital markets have already begun to react disapprovingly to the debt ceiling impasse and that the economy is starting to feel the negative effects.

It started in mid-April when Standard & Poor’s, one of the top three credit rating agencies, revised its outlook on the rating for U.S. debt to “negative.” Much of the reporting about S&P’s changed outlook was about the size of the deficit, but a closer look shows that S&P expressed little doubt about the United States’ ability to pay its debts. Its main concern was over the government’s “willingness to pay,” or its ability to reach the political consensus needed to make timely payments. The fight over increasing the debt ceiling, which raises questions about the government’s willingness to pay existing obligations, had to weigh heavily on S&P’s analysis, especially because the United States is having no problem borrowing and could easily meet its obligations by doing so.

The negative market reaction continued last week when Moody’s, another of the three top rating agencies, warned it was considering a downgrade of the federal government’s credit rating. Moody’s explicitly blamed the debt ceiling fight: The rating agency said the nation’s rating could be lowered if the debt ceiling is not raised “in coming weeks,” and it cited “the heightened polarization over the debt limit” as one of the primary reasons for its thinking.

In other words, and completely contrary to what GOP leaders are saying, two major financial market participants are warning that there will be a Wall Street-related price to pay if the debt ceiling is not raised as needed.

The best indication of all that the market has already started reacting negatively is the current trading of credit default swaps on U.S. debt. As of late May, the number of CDS contracts — essentially insurance policies on the possibility of a default — had risen by 82 percent. Equally as important, the cost of a CDS — the best indication of how much riskier U.S. debt has become — rose by more than 35 percent from April to May. Last week I spoke to a number of people who calculate such things for a living, and they said this change means that the interest rate the U.S. government has to pay has already increased by as much as 40 basis points compared with what it otherwise would be. This means higher federal borrowing costs and deficits, and overall higher interest rates on everything from car loans to mortgages to credit cards.

Except when something unexpected occurs, the initial changes in market psychology and behavior start with just a few investors who act either because they are more or less risk averse, have better information, or are smarter. That means there are usually small signs of change before a market tsunami hits. In this case, there is now clear evidence that the uncertainty over the federal debt ceiling is already having the negative impact on financial markets that the Republican leadership has said will not occur. Just because it may not yet be obvious to everyone doesn’t mean it’s not happening.

Good column You say "there

Good column

You say "there will be a Wall Street-related price." This understates the issue. The costs would likely be huge and borne by everyone.

The Republicans have been claiming uncertainty is negatively affecting the economy. Therefore, the are creating tremendous uncertainty. Their thinking is revealed in this quote from a senior Republican lawmaker, "Who has egg on their face if there is a sovereign debt crisis, House Republicans or the president?"
http://www.politico.com/news/stories/0611/56067.html

In 1979 the Treasury defaulted on some tbill payments due to processing problems. The money was quickly paid, but nonetheless this caused rates to rise by about 60bp for a few months. http://dmarron.com/2011/05/26/the-day-the-united-states-defaulted-on-tre... Think how much an intentional substantive default would cost.


Magical realism

Washington has become a Garcia-Marquez novel. In the Republican world view default (like deficits) doesn't matter and anyways Obama will get blamed, so whats not to like?


The foolishness of the

The foolishness of the Republican position is extreme and obvious. My response to that question would be a question of my own; "Who has spent the last month making a refusal to raise the debt ceiling a significant plank of Party dogma?" In a sovereign debt crisis it would be the Republicans who would take the blame, just as they did with Newt's government shutdown, because they have been all over television owning the creation of one for weeks now.


The S&P Report

"It started in mid-April when Standard & Poor’s, one of the top three credit rating agencies, revised its outlook on the rating for U.S. debt to “negative.” Much of the reporting about S&P’s changed outlook was about the size of the deficit, but a closer look shows that S&P expressed little doubt about the United States’ ability to pay its debts. Its main concern was over the government’s “willingness to pay,” or its ability to reach the political consensus needed to make timely payments. The fight over increasing the debt ceiling, which raises questions about the government’s willingness to pay existing obligations, had to weigh heavily on S&P’s analysis, especially because the United States is having no problem borrowing and could easily meet its obligations by doing so."

This is a complete misrepresentation of the S&P Report issued on April 19, 2011. The S&P report, which hinted that it might downgrade the US credit rating from AAA, didn't mention or even hint that failure, or potential failure, to raise the debt ceiling limit factored into their thinking, much less that "it's main concern" was the "willingness" of the US to pay its debts or to "reach concensus needed to make timely payments". Read the report for yourselves, here:

http://www2.standardandpoors.com/spf/pdf/events/UnitedStatesofAmericaRat...

What the S&P did write, was that they were (and presumably still are) concerned about the ability of the United States to come to a concensus on how to close the medium and long-term budget gap, not on its "willingness to make timely payments". Their rationale had nothing to do with the debt ceiling debate. While they expressed neutrality as to whether this fiscal gap should be closed by raising taxes or cutting spending, they did mention increase entitlements as something that needed to be addressed. They wrote: "Beyond the short- and medium-term fiscal challenges, we view the U.S.'s unfunded entitlement programs (such as Social Security, Medicare, and Medicaid) to be the main source of long-term fiscal pressure." They were particularly concerned that even if some consensus might be reached, the actions taken as a result of that consensus might be too slow in being implemented. They were particularly worried that no action would be taken before the next Presidential election. This is, according to the S&P, in contrast, to actions already taken by the UK and France to reduce their budget deficits.

Again, the S&P Report didn't even mention the debt ceiling issue. But, their stated concern was that Congress and the Administration are dilly dallying on the budget issue. If the condition for raising the debt ceiling is to significantly cut spending, the result of this should be to force action on our fiscal problems sooner rather than later. Based on the rationale that the S&P actually put forward, I would think they would be happy that the issue finally be put to the test rather than a no strings attached hike in the debt ceiling which, once again, just kicks the can further down the road to fiscal perdition.


"...had to weigh heavily on

"...had to weigh heavily on S&P’s analysis..."

is certainly not

"...a complete misrepresentation of the S&P Report issued on April 19, 2011"

because it does not purport to represent the report. Stan's wording is very clear. He doesn't claim to represent the report, so cannot be misrepresenting it. He is clearly offering his own view regarding S&P's motivation. That neither "represents" nor "misrepresents" S&P's report.

The misrepresentation here is yours, of Stan's meaning. Inexcusable, and gassy, to boot.


Thanks, Vivian

Thanks for pointing out what S&P actually said it was worried about. Too many people just don't even see it yet.

What I see is that Wall Street isn't nearly as worried about the debt ceiling per se, as they are about the total unwillingness of Washington to face reality in terms of eliminating the structural deficits and bringing Uncle Sam's spending back in line with tax income.

Some examples:
(1) Gold and silver have risen a lot in the past year. It's not because investors are worried that there will be a deflationary government shutdown! It's because investors are worried that there will be an inflationary spiral unless we break out of our current print-and-spend and/or borrow-and-spend paradigm.

(2) TIPS yields range from -0.5 to +1.8%, whereas historically TIPS have had yields in the 2-3% range. This reflects the fact that historically bonds yield 3% above long-term inflation, but the market currently sees bonds as unlikely to yield as much as inflation (-0.5% TIPS for 5 years) or at most 1.8% above inflation. Again, the fear is of inflation.

Some people claim that Uncle Sam can borrow a lot more, since "interest rates are still low now". But Greek, Irish and Portuguese rates were low, too -- even as they borrowed too much. Once the market woke up, they were doomed.

We need a lot of reprioritization and structural reform in how the government taxes and spends. And we absolutely have to stop borrowing money for no good reason. If we borrow money and never repay the principal, all we're doing in the end is feeding the financial sector a perpetual interest income stream, stripped every year out of our nation's productive output. And I don't think there's much, if anything, on the margins of the federal budget for which we really want to further enslave ourselves to the bondholders!


Not that I don't disagree

Not that I don't disagree with the bond rating agencies are saying--but I would be a lot more comfortable they had not been complicit--and even key--in the sub-prime mess. Their ability to rate crap as AAA beggers the imagination. I really do think that their role in the recession needs to be mentioned in every article about the down grade.

They have feet of clay and we should not forget that.


"...signs that capital

"...signs that capital markets have already begun to react disapprovingly to the debt ceiling impasse and that the economy is starting to feel the negative effects."

"It started in mid-April when Standard & Poor’s, one of the top three credit rating agencies, revised its outlook on the rating for U.S. debt to “negative.”"

Nope. Neither S&P nor Moody's is "the market". They are merely private firms in the business of writing opinions, both educated and questionable, regarding the creditworthiness of borrowers. You could just as well have named any private analyst. Only when you get to the point about CDS markets have you arrived at a "market" judgement. Ratings agencies may get some right that the markets get wrong, but they do not represent markets.


"interest rate the U.S.

"interest rate the U.S. government has to pay has already increased by as much as 40 basis points compared with what it otherwise would be"...ummm with the 10 Year yield at 3.0% where do you see that?

Surely you are not implying that the 10 Year should be trading at 2.5%??


By the way, Fitch has just

By the way, Fitch has just warned that the US will be put on negative watch if the debt ceiling is not raised by August 2 (or whatever other deadline Treasury may announce), making clear that default due to the debt limit is the issue.


Stan S&_ assumption just plain wrong

Completely wrong. If their potential downgrade had anything to do with the current budget ceiling fight then they would have said there was a potential downgrade in the short term.

They didnt and it was the long term rating that they mentioned and when they came out with their report they were talking about a potential downgrade in a couple of years so Stan you are just plain old wrong

"The negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years"




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