Talks in Washington to raise the U.S. government’s debt ceiling and avoid a monumental credit default have turned ugly this week, but you’d never know it based on the markets’ so far sanguine reaction.
With U.S. bond yields barely budging, investors are clearly betting the debt-limit impasse is nothing more than a game of political chicken that, come crunch time, will end in U.S. lawmakers finally striking a bargain.
Let’s hope investors are right. If they aren’t and the Aug. 2 deadline to raise the debt ceiling is missed, it will have serious repercussions for markets around the world and could prompt another fierce sell-off.
“Nobody seems to be too worried; credit default spreads are pretty low, treasury yields are low and the stock market has been reacting to what is going on in Europe, but debt ceiling talks don’t really appear to have had much impact,” said Paul Ashworth, chief U.S. economist at Capital Economics. “To be honest, up until late last week, it looked like we could have a deal. It’s only over the past couple of days that it has gotten a bit testy.”
Since hitting its US$14.3-trillion debt limit in mid-May, the U.S. government has relied on stop-gap accounting to keep creditors paid, but those options are all but exhausted unless the debt limit is raised, U.S. Treasury Secretary Timothy Geithner said Thursday.
While the U.S. Congress has raised the statutory limit on the amount of U.S national debt dozens of times over the past century, the stakes are particularly high this time given the sheer magnitude of the country’s debt burden and the weak economic recovery.
Moody’s Investors Services put the U.S. 96-year-old Aaa credit rating under review for a possible downgrade Wednesday, saying there is a “small but rising risk of a short-lived default” if the debt limit is not raised in time to prevent a missed payment of interest or principal on outstanding bonds and notes.
Meanwhile, U.S. Federal Reserve chairman Ben Bernanke issued a rebuke to lawmakers for failing to raise the debt ceiling. He said Thursday a U.S. default, if it came to that, would hinder investor confidence and raise borrowing costs in critical sectors of the economy.
Despite these warnings, markets appear to be confident a deal on the debt ceiling will be reached. At the very least, there’s no reason to panic just yet.
“This is supposed to be a big battle of wills,” Mr. Ashworth said. “This is the type of thing that you expect people to be banging on the table to finally get a deal in place.”
If a deal is reached in time, Mr. Ashworth believes markets will likely carry on as usual. But in the event a deal doesn’t get done, it’s difficult to predict just how markets will react, largely because the U.S. debt ceiling has never been breached.
For one, it’s possible the U.S. government will simply ignore the debt limit and continue to creatively pay it’s creditors until a deal can be reached. In that case, the market response may be muted.
Alternatively, it may prioritize debt interest payments so there is no formal default on treasuries, in which case it could still cut spending to social security and delay payment to vendors.
The latter approach would presumably have some impact on equity markets, he said, notably for S&P 500 retailers who would get hit if social security checks weren’t written. Equally, defense stocks might get hit if the U.S. government stopped paying instalments.
“Federal government spending represents 21% or 22% of overall GDP, so if you curb that to something affordable it will have a significant impact on spending and if it continues, that will impact equity markets,” he said.
“But a lot of this depends on how long it goes on. Everybody remembers the initial failure to pass the TARP bill that led to a very sharp drop in equity markets. But TARP got passed the next day and stocks rebounded.”
Peter Buchanan, a senior economist at CIBC World Markets, said the outlook could be much bleaker if failure to raise the debt ceiling results in a technical default.
“The U.S. dollar would likely lose ground in such an event, along with equities, as risk-averse investors sought out alternative havens,” he said.
Ultimately, Mr. Buchanan thinks markets have it right and believes odds are tilted heavily against default. The more likely outcome from a political perspective, he said, appears to be an interim agreement that averts default, but leaves serious longer-term fiscal challenges unresolved.
“We are in untested waters, but if default were to happen it would be pretty bad. People are still assuming the politicians will do the right thing, or at least the safe thing and raise the ceiling before everything comes crashing down.”
Source: National Post
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