(Recasts to reflect tentative budget deal)
With less than a week to go before the US runs out of money to pay its bills, you’d have been forgiven for thinking that very few investors actually care.
Whether that belief was justified when Congressional leaders struck a tentative two-year budget plan which would defer the next battle beyond the 2016 presidential elections is debatable.
Investors remain happy to walk to the edge of the budget cliff with politicians, a fact that tells us much about the world: that when it comes to the big issues like default, investors put tremendous, arguably naive, trust in officialdom.
There were few sizable moves in prices traceable to the prospect of the US hitting the debt ceiling, something that, absent a deal, would have happened Nov 3.
In the days before the deal, short-term Treasury bills had been hit, sending minuscule yields higher by commensurately small amounts, but even when the Treasury last week canceled an auction planned for Tuesday the result was far from carnage.
Taking a broader look at risk assets, the debt ceiling issue has coincided with a 7.5% rally in the S&P 500 over a month and the highest inflows into high-yield bonds in eight months last week.
Granted, all of that may have more to do with the expectation that the Federal Reserve will wait a while more before raising interest rates.
Investors may complain that the political system is broken, but they fail to see how that is a problem for them. That’s in large part because of the huge natural appetite for safe assets – and even a week before running out of cash, the US is as safe as it gets.
Investors have also drawn a lesson from recent history: that politics aside, policymakers, often central bankers, will pull their fat from the fire. That belief, supported by events of the Great Financial Crisis and the European debt affair, may be naive but is now a feature.
It has also not escaped investors’ notice that although markets have been hit with varying intensity in both previous debt ceiling episodes, in 2011 and 2013, in both instances a deal was done and chaos averted.
And so it seems it will be this time.
The agreement must still be approved by the House and Senate. The Treasury has warned the government will default if the ceiling isn’t raised by Nov. 3, at which point the government may have as little as US$30bn on hand.
Equities down, treasuries up?
Based on past episodes, movements in financial markets surely will get larger as we approach Nov 3 should the new deal be scuttled or delayed.
Equities, in this scenario, will sell off; after all the only balm in the story for stocks is that the Fed surely won’t raise rates while negotiations are ongoing, a position they likely have reached anyway for other reasons.
Equities did fall sharply during the 2011 debt ceiling crisis, and were especially hit hard when Standard & Poor’s downgraded the US’s credit rating. The stock market fell too in 2013, but by less, perhaps taking heart from 2011’s ultimate resolution.
“The other side of this is that, perhaps counter-intuitively, long-dated Treasury yields could fall,” Andrew Hunter of Capital Economics in London wrote in a note to clients.
“Of course, investors might worry about a delay or temporary default on coupon payments. But such fears would probably be outweighed by an increase in safe-haven demand and growing expectations that the Fed would remain on hold for longer.”
The salient fact isn’t that US debt becomes more risky during a debt crisis, it is that it is still the safest liquid asset out there. Investors react to the US becoming less safe by lightening up on risk, which, as the US remains safer than stocks or foreign bonds, argues for selling stocks while buying up Treasuries. To be sure, short-term rates spike in these episodes, upsetting money markets.
It is probably true that the drip, drip, drip of US political dysfunction is having a cumulative effect on its store of credit among investors. Eventually, the price of this may rise, but certainly not at a time of stagnant growth when central banks around the world are preparing to ease further rather than hike.
Those, like Treasury Secretary Jack Lew, who bemoan the risks that this process runs are quite right, but thus far the actual butcher’s bill has been low enough to be safely ignored.
Whether due to a long track record of holding it together politically, or the faith that the “grown-ups” like central bankers will help cushion any blow, the US has enough credit to allow it to some day sleepwalk its way into real trouble.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
