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Here's what all the fuss is about -the hype vs. the reality

Speculation about the outcome of the US budget and debt ceiling battle was the prime market mover last week, and is a likely prime driver of global asset markets this week.

For those seeking to distinguish between the hype and reality, or in need of a review of how this issue does and does not matter, here's a quick guide.

The list of bad things markets are hoping to avoid includes:

  1. Chaos: No one is really sure, but it won't be good, and that's the thing that's key here. This is really the big one, both in terms of market uncertainty (so a big selloff is expected by many if October 17 passes with no deal imminent) and the reality of how the US government continues to function. With its borrowing capacity limited, the U.S. Treasury Department may go into default and eventually be forced to prioritize its payments. However it's far from clear that there is any such plan extant on how to prioritize payments, nor is it clear that even if the Treasury had one, it would be legal. See here for details. Obviously no one wants vital services or payments to halt, but currently that's what would soon happen, if the 80 million payments per month continue and quickly overwhelm the Treasury's $30 bln of emergency cash reserves. Again, past experience suggests a last minute deal will be found. Heck, even newly appointed Fed Chairperson Yellin has hinted at a third Fed mandate to keep paying US obligations.
  2. Wild Market Volatility: That much uncertainty and risk causes selloffs, which, if given a few days, can take on a life of their own as program trades kick in. Big time. That volatility can be very profitable for those skilled at playing it, but for most investors it's just upsetting and so politicians know it makes voters mad. This volatility risk is well understood by all concerned so again, that suggests there will be a deal, albeit likely a last minute, and temporary deal that brings us right back to this same crisis-thing before year's end.
  3. Wrote Goldman Sachs' Alec Phillips and Kris Dawsey: "We estimate that the fiscal pullback would amount to as much as 4.2% of GDP (annualized). The effect on quarterly growth rates (rather than levels) could be even greater. If this were allowed to occur, it could lead to a rapid downturn in economic activity if not reversed very quickly." Some believe the damage to GDP could be as high as 0.1% per week or more.
  4. Damage to consumer confidence that could hurt retail sales during the vital Christmas shopping season. Gallup's economic confidence index - has now dropped to -35 from -17 a month ago, as citizens worry about fallout from the government impasse and a growing number of Federal employees (and those dependent on them) aren't getting paid. The longer the budget battle drags out, the more difficult it will become to repair damage to the US economy and that could have more negative consequences for the US dollar.
  5. Additional damage to US credibility and credit rating: The last major budget fight in 2011 cost the US its AAA S&P credit rating because the credit rater believed (correctly thus far) that the US lacked the political will to solve reduce its deficits and debt in a responsible and timely manner. The subsequent budget battles, in late 2012 and now, only serve to confirm that belief. An extended deadlock risks further such damage. That will likely bring…
  6. Rising US borrowing costs: As the Oct. 17 deadline for hitting the legal debt ceiling continues to inch closer, short term rates keep rising: For example on Tuesday they surged again, suggesting markets are getting more worried. A $30 billion auction of four-week bills had them priced for a 0.35% yield -- the highest since October 2008.
  7. Continued battering for the USD and thus GDP: The more economic damage done from the budget fight, via the damage to GDP, increased US borrowing costs, lost jobs, etc., the more likely the Fed will continue its bond buying programs, which are seen as USD dilutive. The longer markets believe there will be no material reduction in QE, the longer the USD remains under pressure. The US is a net importer, so a USD decline hurts the US more than it helps (via making exports cheaper).
  8. Government shutdown means blackout on federal government supplied economic data: That includes a wide variety of data including US jobs, retail, commodity prices etc. That lack of data hinders not only these markets from functioning properly, it also prevents the Fed from making informed decisions about its next moves.

I could come up with a few more, but that's the basic list.

As of this writing, there is still no deal; however markets remain calm in the assumption that Congress wouldn't be so stupid as to let the deadlock drag on long enough to cause significant damage or a default. That confidence erodes with each passing day.

Don't Be Surprised If There Is No Deal By October 17th

So what terrible things befall us on October 17th if there's no deal? Probably not much, actually, at least not right away.

This is when the US is expected to hit the debt ceiling and be unable to issue more debt. However the US probably has another week before it must actually default, because the Treasury keeps an extra $30 bln around for emergencies. This is important to know because given the current brinkmanship both sides are using, a deal may come only when Congress truly believes it's the last minute. Only then can both sides turn to their supporters' eyes aimed piously skyward, and claim they had to make sacrifices for the greater good.

See here for details.

The Most Likely Outcome?

The consensus appears to be that at minimum we get some short term deal that gives Congress a month or two to work out a longer term deal. If so, that likely means some kind of short traders' relief rally, followed by a return of bearish pressure on markets, is repeated as yet another deadline inches closer.

Whether or not that fear will be felt in the weeks ahead would depend on whether there are other positive or negative surprises (earnings, new sentiment on the size and duration of QE, a new EU crisis, etc.).

The Hype Vs. The Reality

In sum, markets aren't really afraid of a default as much as the uncertainty and ramifications of the rising risk of default.

Ramifications: If Debt Ceiling Hits And No Imminent Agreement

As noted above, the US has a few days of wiggle room, maybe more if it gets creative.

In essence, risk assets down, safe-havens up. If you're not fully versed in what those are, or in their currency equivalents, then see here, and here. There are a few obvious exceptions. For example, the normally safe-haven USD would take a hit because the ensuing damage to the US economy could mean more dollar dilutive QE, and for a longer period. Also US debt coming due would likely see its prices fall.

We won't delve deeply into this because of the low chance you'll need to know.

The big question is how long markets can stay calm after October 17th passes without some special emergency measures designed to calm markets. Expect those. If markets do panic, it's an opportunity to buy what is being sold and to sell what is being bought. This 'crisis' is a largely manufactured one for political purposes of the dueling parties.

Once they see the political benefits gone, and they will once voters sense real damage is starting to hit, then it's very likely a deal gets done.

The only question is what strikes first, the politicians with a last minute deal, or the computers that hit panic sell mode before Wall Street can hit the escape button on those programs.

See here for more on this week’s likely market drivers to watch.

Source: U.S. Debt Ceiling Guide: Hype Vs. Reality