The Washington Hurdles

While President Obama is now beginning his second term, the new Congress isn’t expected to “get down to business” until next month. There are three hurdles for Washington, which are likely to have significant implications for the financial markets.

The Debt Ceiling. Treasury reported that the national debt exceeded the $16.4 trillion debt ceiling on December 31, but added that it has the ability to take “extraordinary measures” to pay the government’s debts until sometime between February 15 and March 1. However, with a delay in tax returns this year (a consequence of late action on the fiscal cliff), the “drop dead” for the Treasury may end up being within the first 10 days of March. Whatever the case, the debt ceiling must be raised. Recall that the debt ceiling does not authorize spending. It merely permits the Treasury to meet obligations made previously. Raising it is often political. Obama voted against raising the debt ceiling when he was a senator and current Republican leaders had no problem with voting for several increases in the ceiling during the previous administration.

President Obama has said that he wants a clean increase and will not negotiate on the debt ceiling. However, he has said this kind of thing before, only to come to the table later. There’s always some budget agreement tied to debt ceiling increases.

While the debt ceiling is widely expected to be raised, there are two significant concerns for the markets: the possibility of a default and the danger of a downgrade.

If the drop dead date passes, Treasury will be unable to pay roughly 40% of its obligations. It could then prioritize its spending, with interest payments at the top of the list. This would avoid a legal default. We saw a partial shutdown of the government in the Clinton years, and that came without serious and permanent repercussions in the financial markets. Of course, a lot depends on how long the partial shutdown continues (and note, it would end up costing the government more than if the partial shutdown hadn’t occurred). The greater danger would be a downgrading of U.S. government debt.

Standard and Poor’s downgraded U.S. government debt in the summer of 2011. Recall that this downgrade had little to do with the ability of the U.S. to pay its debts. Rather, it was a political statement. S&P’s downgrade was a comment on the inability of the two parties to work together to reduce the deficit. Long-term interest rates fell after the downgrade, but that was surely due to other factors (concerns about the strength of the economy, worries about Europe, etc.). The impact of a second downgrade would likely depend on the reason. Another “political statement” would probably not be taken too seriously. However, S&P is not the only rating agency.

Some institutional investors are required to invest in high-quality securities, but have the option of choosing two of the three rating agencies. Thus, the S&P downgrade was no big deal as long as Moody’s and Fitch did not downgrade. In turn, a downgrade by one of the other two rating agencies could set the dominos toppling. We may see a run on money market funds. A downgrade of agency debt would occur simultaneously with a downgrade of government debt. Dislocations and counterparty risks in the fixed income markets could escalate rapidly. Nobody is looking for this to happen. It’s widely expected that a deal on the debt ceiling will be reached. However, the longer it takes to get to a deal, the more uncertainty for the financial markets. So, have a nice day.

The Sequester. The American Taxpayer Relief Act (the fiscal cliff deal) postponed spending cuts from January 1 to March 1. These cuts would amount to $85 billion this year (about 0.5% of GDP), with about half of that falling in defense. Republicans generally believe that this is a done deal, but no lawmaker wants to see cutbacks in his or her district. On the whole, Washington isn’t prepared for the spending cuts. For example, suppose you are a manufacturer and have a contract to deliver widgets to the Department of Defense. Will that contract be voided if spending cuts kick in? It depends (and no one seems to be sure). It would likely depend on the source of the funding (not all spending is created equal) and when the contract was signed (assuming there’s no escape clause). As with the run-up to the January 1 deadline, Washington still has no clear plan on the spending cuts. Even if there’s no deal on spending by March 1, many expect spending to continue at existing levels, with the assumption that it will be “fixed” later on.

The problem with the sequester is the same problem with the longer-term budget outlook. It’s easy to talk about spending cuts in general, but extremely hard to be specific about what to cut. Don’t think that this falls neatly along party lines. In the presidential election, Mitt Romney had difficulty listing what spending he planned to eliminate (other than Big Bird) and Republicans spent like drunken sailors when they controlled the White House and both chambers of Congress. One person’s pork is another’s bread and butter.

If the sequester is postponed further, the (limited) long-term deficit reduction of the fiscal cliff deal will be questioned, which could hasten a downgrade of U.S. government debt.

The Continuing Resolution. This is the easy one. Absent a real budget, the current CR (which authorizes government spending) expires on March 27. There may be some political posturing ahead of that deadline and a small chance of a serious deadlock, but we’re almost certain to see another CR.

© Raymond James

© Raymond James

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