Government Down, Markets Up
Equity markets gyrated back and forth over the week, but signs of thawing in the government shutdown negotiations led to a sharp rally on Thursday and Friday. By the end of the week, the DJIA was up 1.1% and the S&P 500 gained 0.8%.
Economic news was on the light side last week given the government shutdown, but we learned that President Obama intended to nominate Janet Yellen to succeed Ben Bernanke as head of the Federal Reserve. The Yellen nomination was viewed favorably by markets as she is not expected to make sudden changes to preexisting policy, and will likely delay the wind down of Fed asset purchases for an extended period.
Minutes from the September FOMC meeting offered a glimpse into a divided Fed. Certain members of the committee felt the time was prudent to scale back on asset purchases, but others thought incoming data was not at a level to warrant asset purchase reductions.
Three pieces of data did garner attention last week. On the heels of the government shutdown, consumer sentiment declined from 77.5 in September to 75.2 in early October. The decrease was driven primarily by the expectations component rather than current conditions.
Consumer balance sheets took something of a hit in August, with consumer credit outstanding increasing by $13.6 billion. Non-revolving credit, which captures auto and student loans, posted a $14.5 billion rise. Revolving credit, which primarily covers credit cards, was down $0.9 billion. It is generally a positive development that consumers are using less credit debt, but this is the third month of declines in the revolving component and points towards a weakening trend in consumer spending.
Following a period of strange movement, initial claims for unemployment insurance jumped from 308,000 to 374,000. According to reports, half the increase was due to technical glitches in California, while 15,000 claims were associated with the federal government shutdown.
As the government shutdown drags on and compromise appears far away, certain market participants are expressing their displeasure. Yields on short-term Treasury debt rose sharply in the last several weeks, resulting in an inversion of the Treasury curve (short-term rates above longer-dated rates).
Concern about the potential for the U.S. Treasury to run out of funds on October 17 caused many firms to sell short-term holdings. JPMorgan Chase, for instance, said it sold all short-term U.S. government debt, as did Fidelity Investments. Fidelity took similar action in August 2011 when Standard & Poor’s downgraded the U.S. debt rating and fears about a default were widespread.
US Default: How Bad Would It Be?
Treasury Secretary Jack Lew has publicly declared October 17 – this Thursday – as the date when the US government would no longer be able to pay its bills, should Congress not reach a budget resolution. A once unthinkable outcome is becoming all too close to reality due to brinksmanship in Washington. For the second time in two years, investors have had to contemplate just how such a situation would shake out for financial markets.
The first point of consideration is what exactly will happen on October 17, absent a resolution? One outcome is that the Treasury prioritizes which bills to pay (although Secretary Lew has steadfastly rejected this possibility). The government’s obligations stretch beyond just bond interest payments, including entitlement benefits, federal worker compensation, and military salaries. In the strictest sense of the word, a US default may only include failure to pay back its creditors – at least in the eyes on financial markets. To that extent, it is expected that the government could continue to pay bond interest and principal alone beyond the deadline. However, some media outlets have suggested it logistically impossible for the Treasury to execute such a plan.
In a letter to Speaker of the House John Boehner in late September, Treasury Secretary Lew estimated that the Treasury would possess $30 billion in cash on hand on October 17, in addition to any revenue the government brings in. He went on to note that the sum of total daily obligations can reach $60 billion. According to the non-partisan Congressional Budget Office, cash inflows (primarily from remittances by employers of income and payroll taxes withheld) average about $7 billion per day. One can quickly see that the math does not work for the government, although the CBO has estimated the Treasury will more likely run out of cash between October 22 and November 1.
While consensus suggests that it is highly unlikely that Congress fails to increase the debt ceiling before the deadline, there is a realistic possibility that the US could find itself having to delay interest or principal payments by a few hours or days. This possibility appears to be filtering through to the yield curve, as mentioned in our recap section above, as shorter-dated bonds are selling-off while longer-dated ones remain fairly stable.
Some might be surprised to learn that this would not be the first time the Treasury has delayed payment to its creditors. In April 1979, the department delayed payment of $122 million in maturing principal to creditors for more than a week. Then, too, legislators wrangled over the debt limit until a last minute resolution was reached. However, due to processing issues, the Treasury was unable to turnaround the claims quickly enough. In that instance, T-bills spiked 0.6% and led to structurally higher rates moving forward.
The implication is that a “temporary default” would not be disastrous, albeit with a considerable amount of indigestion for financial markets. Of course, in 1979 an expanded debt ceiling had already been agreed to; no such indication of repayment would be clear in today’s hypothetical scenario. Some analysts believe that legislators could push the country into this situation before striking a deal.
If the aforementioned case is the “good” outcome, at the other end of the spectrum is outright Armageddon that knocks the global economy back into recession (if not depression). The ubiquity of US Treasuries as collateral for repo agreements, derivatives contracts, and other financial agreements could lead to a Lehman-style unwind that sucks out liquidity and sends borrowing costs skyrocketing.
The magnitude of such a situation would be infinitely larger. As a recent Bloomberg article noted, the “$12 trillion of outstanding government debt is 23 times the $517 billion Lehman owed when it filed for bankruptcy.” And unlike 2008, the Federal Reserve has very little ammo to fight off another financial crisis. The 57% max decline experienced in the S&P 500 might seem quaint in comparison.
To be fair, the Lehman situation involved an entity’s inability to pay; as with any sovereign, the US government’s payment to creditors is based on its willingness to pay. This fact could assuage investors that the delay scenario is more likely than an outright default – potentially mitigating a wholesale firesale of government securities.
Whatever the outcome, the long-term ramifications to the United States’ reputation
and its ability to borrow in global markets are likely more negative than any short-term event. Even the most pessimistic of observers believe the government will construct an agreement to avoid the most detrimental effects of a default. Arguably, though, the damage has already been done, as investors have once again been taken to the brink by a dysfunctional legislative apparatus.
The Week Ahead
The market focus remains on the debt ceiling and the budget impasse. There was little over the weekend to suggest politicians are nearing an agreement, but markets will closely hang on every word from politicians.
A range of data from China will be released with the potential to drive markets. This includes CPI, GDP, industrial production, and retail sales.
Only a handful of central banks are meeting this week, including those in Russia, Thailand, and Chile.
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