Debt Ceiling 2013: Déjà Vu All Over Again. Or Is It?
In the summer of 2011, the rancorous debate surrounding efforts to raise the US debt ceiling sparked widespread market volatility and resulted in an unprecedented downgrade of the rating on US long-term debt from AAA to AA+ by Standard and Poor’s (S&P). Compare that to the current debt ceiling crisis, and you may be reminded of Bill Murray in Groundhog Day. But should you be?
On the surface, political kabuki theater and doomsday rhetoric in the press are once again running high as the Oct. 17 deadline nears. And, like in 2011, as political negotiations started, markets all but ignored Washington and the media. But the underlying political and economic fundamentals are quite different today than they were two years ago. Politically, the US government is far more polarized now than it was in July and August 2011. Since then, policymakers have clashed continuously — on everything from the fiscal cliff and sequestration to Obamacare. The economic fundamentals, however, are stronger. The fiscal deficit has shrunk significantly while employment and housing numbers have improved. Moreover, the US Federal Reserve’s (Fed) continued stimulus in the form of quantitative easing (QE) has helped support asset prices.
A closer look at some of the battling tensions that have been playing out may help explain the market’s reaction to events so far — and help anticipate what that reaction will be as key deadlines approach.
The role of the debt ceiling
At least part of the reason for the muted market in the face of the government shutdown is that — as callous as it may sound with more than 800,000 federal employees furloughed — the debt ceiling matters more. Bad public policy happens. The fiscal cliff, sequestration and the government shutdown are all examples of really bad policy choices — ones that carry negative economic consequences. But, as has been widely recognized, this is not the first and probably not the last time the government will experience a shutdown. Congress hasn’t passed a budget for the federal government since 1997. And the sky hasn’t fallen yet. Equally important for markets, these events have yet to significantly affect the bottom line of most US companies.
However, if Congress fails to raise the debt ceiling, it increases the risk of the US defaulting on its debt — something the US has never done — and in doing so, would severely undermine our creditworthiness as a nation. That means a default could threaten the US relationship with China, the third-largest holder of US Treasuries — a twist complicating the decision-making process for policymakers. And the credit ratings agencies are watching. (For more on credit rating agencies, read the blog series Credit Rating Agencies: Can They Get it Right?) So far, Moody’s Investors Service and S&P haven’t indicated they are considering a downgrade. They believe that Congress will raise the debt ceiling in time. Fitch Ratings has noted that a formal review of the US rating (currently AAA with “Negative” outlook) would be triggered if the debt ceiling is not raised in a timely manner. The closer we get to the Oct. 17 deadline without a resolution, the more nervous markets will likely become.
The role of the Fed
The Fed shocked most market participants in September by announcing it would not taper, or slow down, the rate of its asset purchases. Part of its rationale for doing so — for keeping the current level of QE — was concern over upcoming policy headwinds, such as the budget and debt ceiling. So heading into the current round of political turbulence, markets had a safety net in the form of monetary stimulus. Moreover, given the ongoing nature of this turbulence and delays in data gathering due to the government shutdown, the Fed could postpone tapering even further, keeping interest rates low for longer. That might also explain some of the rationale feeding into market behavior. Finally, President Obama is expected to nominate current Fed Vice Chair Janet Yellen to head the Fed — a move that the market expects, and to which it has had a generally positive reaction.
The role of the investor: ‘Fool me once …’
According to the Financial Times’ Gavyn Davies, current market reaction is consistent with past behavior because “it has become very clear in recent years that asset prices are not necessarily very good at reacting in a smooth manner to changes in the perceived risk of extremely unlikely events taking place. For long periods, the markets do not react at all, and then they suddenly react in a discontinuous manner.”1 We have witnessed this market behavior several times in recent years: in the run-up to the 2011 debt ceiling, to the fiscal cliff in 2012 and to sequestration earlier this year.
Davies goes on to explain that this is because from the perspective of the individual investor, the cost of hedging against low-probability, high-impact events — like breaching the debt ceiling — outweighs the benefits. It’s like buying hurricane insurance. No one wants to spend the money for it upfront because it’s likely to expire unused. But when a storm is on the radar and getting closer — as the shutdown drags on and the debt ceiling nears — the larger the risk appears. Only then does everyone scramble to try and protect themselves. In the market, that translates into large asset shifts that generate market volatility.
At the same time, today’s investors have learned — through this series of unfortunate policy events — that these largely manufactured crises, however dire, ultimately get resolved. So, how likely are you to react quickly to the current round of political wrangling?
Put simply: Fool me once, shame on you. Fool me twice, shame on me.