Prepare for a Sell-Off When the Debt Deal Is Struck

by: Adam Stauffer

Prediction markets, like Intrade, are by no means the be-all and end-all when anticipating the likely outcomes of future events. Many times they can be thinly traded or poorly designed, among other issues. However, prediction markets can be a very useful tool for gaining information on an unknown future event and provide an additional data point to fill in missing or unclear information. So with that said: What does Intrade predict for the timing of a U.S. debt ceiling increase?

Congress to approve increase in U.S. debt ceiling to $15.1T or more before midnight ET 31 July 2011

This contract rallied after Thursday’s (July 7, 2011) meeting between Obama and Congressional leaders where House Minority Leader Nancy Pelosi pledged her “full cooperation” and House Speaker John Boehner appeared optimistic about a deal. Despite this increase, a 50/50 split still suggests that the July 22 soft deadline will probably be missed, leaving very little wiggle room to meet Treasury Secretary Tim Geithner’s August 2nd hard deadline.

Congress to approve increase in US debt ceiling to $15.1T or more before midnight ET 31 August 2011

On the other hand, the contract that expires August 31 suggests a much higher (75%) likelihood that a deal will be struck sometime in August (although whether this is before or after the August 2nd deadline is impossible to tell).

The fact that this number is not much closer to 100% surprises me. If a deal is not done, then I expect U.S. and global markets to react swiftly and significantly to the downside. With a sufficiently severe selloff (which I think is safe to assume), Congress would scramble and quickly do an about face to get a deal done before the end of August. This would be very similar to what happened when the first round of TARP failed to pass in September 2008 but was quickly reconsidered and passed several days later.

Bottom line: The markets will be influenced heavily by politics over the next several weeks. If/when a deal is struck we expect equity markets to sell-off on the news and then focus on the terms of the deal. If the deal is skewed too far in the favor of either political party then the sell-the-news downturn could be more protracted and severe since this will likely mean the austerity ax was wielded too freely or taxes hiked too broadly.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.