Debt Ceiling: Positive Signs Emerge From Washington
It appears likely to us that a deal on the debt ceiling may be worked out in the coming days, allowing the US to avoid a near-term default. This deal is likely to come in the form of a short-term extension of the debt limit for six weeks or so. This could either be accomplished through increasing the debt limit by a small amount, along the lines of what has been proposed by Congressman Paul Ryan, or through suspending the debt limit entirely for a certain period of time. This would give the Democrats the clean debt limit increase that they have been asking for, and the Republicans would be able to start some negotiations with the administration during this period.
The White House seems to be somewhat accepting of this option. White House Press Secretary Jay Carney said today that President Barack Obama would support a short increase in the US debt limit with no “partisan strings attached,” though he prefers a longer extension. House Republicans haven’t specified what they plan to tie to the measure, and Carney said the White House would need to see a bill before accepting it.1 It is likely that Democrats will take the lead from the White House in analyzing any Republican proposal.
For the time being, the debt ceiling issue will be separated from the government shutdown. If this is what is needed in order to get a solution to the debt ceiling issue, then we view this as a positive development. In our view, the government shutdown does impact the economy and is likely to be a drag on fourth-quarter gross domestic product (GDP) growth of around 0.15% for every week the government is shut down, but the effect is not catastrophic. The impact of a default or near default would be catastrophic. The government shutdown will likely continue for a while and will be part of ongoing negotiations regarding spending. It now appears that these negotiations have moved past defunding Obamacare and will be concentrated on spending and entitlement reform.
The increased likelihood of a near-term resolution to the debt ceiling crisis has relieved pressure on financial markets today. Yields on Treasury bills maturing near the end of October had increased sharply in recent days, but are declining again, and risk assets, including equities and credit, are doing better.
Looking forward over the next couple days, it is important to watch for additional positive signals from the White House on a short-term extension to the debt limit.
If events develop along these lines, we will avoid near-term calamity, but there will be ongoing negotiation around the government shutdown and longer-term extension of the debt limit. We believe the US economy will continue to be negatively impacted by the shutdown and continued uncertainty. A weaker economic outlook for the US will keep the US Federal Reserve (Fed) in a dovish posture and removes the possibility of near-term tapering of quantitative easing (QE).
Events at the Fed
The much-awaited Fed minutes from the Sept. 17-18 meeting were released on Oct. 9. There was clearly a vigorous discussion of whether tapering of the $85 billion per month in asset purchases should begin in September or be delayed. The minutes don’t really give any clues as to how many Fed members were in favor of tapering immediately or how many preferred to delay tapering to a later date. The argument that the economic conditions had not improved enough to justify reducing QE seems to have been the driving force behind the Fed’s decision not to taper. There was also concern that rising interest rates had excessively tightened financial conditions. The counter argument in support of tapering was that since the market expected tapering, the Fed’s credibility might be damaged by not tapering. In the actual vote, all voting members but one (Esther George) were in favor of waiting for more evidence of a strengthening economy before they begin to taper.
The Fed’s remaining meetings this year are in October and December. Clearly, many Fed members would like to begin tapering, but the extended political issues discussed above are likely to keep the Fed cautious on tapering for the near term. Additionally, we believe the nomination and likely confirmation of Janet Yellen as the next Fed chairman mean that policy will err on the side of being overall dovish in the future.
IFI’s view has been and continues to be that 10-year Treasuries will fluctuate in a range of 2.25% to 3.0%. We have been modestly overweight duration as Treasury yields have moved from the top of this range toward the middle. The events outlined above only serve to reinforce the Fed’s easy stance, but in our view do not presage a significant downturn in growth. Should more positive news come out of Washington on the debt ceiling, we would move to a more neutral duration position. Given our expectations for modestly positive growth and continued easy monetary policy, we view risk assets, including credit assets, favorably. Further, we believe the removal of uncertainty regarding leadership at the Fed and any forthcoming positive news on the political dynamic in the US is positive for the US dollar at the margin and pro risk currencies.
1 Source: “Debt-Cap Raise Until Nov. 22 Gains Support to Avert Default”, Bloomberg News, Oct. 10, 2013
Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period.
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