Policy, U.S.

Markets Fiddle While D.C. Burns

October 16th, 2013 | By Nick Sargen

Highlights

  • It now appears the two political parties may not reach an agreement to extend the debt ceiling before October 17, when the U.S. Government no longer can issue new debt to finance its obligations. Despite this, financial markets remain remarkably calm.
  • There are two reasons: (1) investors understand the Government has flexibility to service its debt until the latter part of this month; and (2) they also believe the political leaders will reach a compromise before then to extend the debt ceiling into early 2014.
  • The risk, however, is that politicians could miscalculate and wind up with a technical default (or missed payments). If so, it could unleash ripple effects in money markets and short term funding vehicles, as the use of short-term Treasury debt for collateral would be hindered.
  • Consequently, we have eliminated any exposure to near-term Treasury obligations.
  • Given the fluidity of the situation, we will send out updates as circumstances dictate.

Negotiations May Extend Beyond October 17

In a script that could only be written for television comedy, the two political parties may not reach an agreement to extend the debt ceiling before October 17 – the date when Treasury Secretary Lew has indicated the U.S. Government runs out of "extraordinary measures" and can no longer issue debt to finance its obligations. While the Senate is drafting a bill to re-open the government and extend the debt ceiling deadline until early 2014, reports we are receiving indicate negotiations with the House of Representatives will likely drag on over this weekend.

Despite this, financial markets have remained remarkably calm even as headlines in the media suggest "D-Day" is at hand. While we are surprised by the markets' equanimity, we suspect it reflects two considerations.

First, there is nothing magic about October 17. While Treasury Secretary Lew singled out this date, the U.S. Government will have about $30 billion in cash on hand, which the Congressional Budget Office estimates should tide the government through October 23, when it is scheduled to pay $12 billion in Social Security benefits. By the first of November, the Government is scheduled to make $55 billion in payments to veterans and recipients of Social Security, Medicare, and Medicaid. The true "default" date, therefore, is probably closer to the end of the month.

Second, investors also remain hopeful that the two political parties will be able to reach an agreement before then to re-open the government and extend the debt ceiling into the early part of 2014. Last week, the stock market recouped most of its losses in prior weeks amid reports that the two sides were seeking a compromise solution. And it has held its ground even as October 17 approaches. The prevailing mood is that politicians always wait until the last hour to reach a compromise, and this is likely to be the case once again. After all, how hard can it be to reach a compromise to extend the debt ceiling and "kick the can down the road" one more time?


A Miscalculation Cannot Be Ruled Out

While we share this sentiment, we also believe it would be a mistake to rule out the possibility of a miscalculation. Indeed, watching Washington politicians in action makes us realize that some of the players may believe a technical default could be a positive development. If so, there is a risk that a compromise may not be reached in time to avert a missed government payment.

This begs the question of what would happen if there were a brief technical default. Some observers contend the government would prioritize payments to ensure that it services its debt. However, the consequences would be a significant cutback in government spending. We do not pretend to know the answer, but either outcome – a technical default or a large-scale cutback in government programs would be very damaging and would lead to a loss of investor confidence about the integrity and safety of U.S. financial markets.

The area of the markets that would feel the fallout initially would be money markets and other short-term funding vehicles. In fact, yields on near-dated Treasury bills have spiked recently. The reason: if the Treasury is unable to repay maturing debt, the debt can be extended on a rolling basis, but will technically be a defaulted security. Defaulted securities cannot be transferred via the Fedwire and cannot be used as collateral for repo transactions or other collateral accounts. A defaulted Treasury bill will create difficulties in the daily operations of repo and liquidity markets, because there is no precedent and systems generally cannot process defaulted securities.

Recognizing this risk, we are not holding any near-dated Treasury instruments and we are maintaining excess liquidity. However, we are not altering our equity or fixed income strategies at this time, because we believe it is impossible to time the markets in these circumstances.

Finally, in light of the fluidity of the situation, we will provide updates as circumstances dictate.