10/8/13 – A Deeper Look at the Crisis

Posted by Brad McMillan, CFA, CAIA, MAI

This entry was posted on Oct 8, 2013 9:21:56 AM

and tagged Market Updates, Politics and the Economy

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As we move into the second week of the shutdown—and another day closer to running out of room to maneuver around the debt ceiling—cracks are starting to appear.

On the political level, there’s an apparent disconnect between a White House potentially willing to accept a short-term rise in the debt ceiling and a Senate holding out for a longer-term deal on the Democrat side. In the Virginia governor’s race, the Democrat appears to be gaining an edge from the shutdown. The Senate Democrats are talking about passing a clean continuing resolution themselves, rather than waiting for one from the House Republicans—who have been taunting them about their unwillingness to force Democrat senators to make a potentially tough vote. In short, we’re seeing the usual political circus.

Back in reality, the Treasury continues to run out of money. The “usual extraordinary measures,” a phrase that makes me angry every time I see it, are about to run out. The first extraordinary measure was to stop issuing Treasury securities to back up the issuance of municipal securities. In other words, back in May, the Treasury stopped helping cities and states save money by issuing lower-interest-rate bonds. The second extraordinary measure essentially consists of issuing IOUs to the retirement plan for federal and postal service workers—and spending the money. Note that these funds will have to be paid back, with interest, once the standoff is resolved. The third extraordinary measure is the same as the second, for a different federal retirement plan. The fourth and final measure, which the Treasury started using on October 1, is eliminating, on a temporary basis, the exchange stabilization fund.

If you look at the actual numbers, we’re down to pretty small amounts in the context of federal spending—not quite change under the cushions, but almost. The fact that we’ve hit this point at all means the wall is pretty close.

The final crack we may be starting to see is in the financial markets. The stock market has been pretty sanguine so far, based, I expect, on the assumption that a last-minute deal is inevitable. This may be a bad thing, in that it took a market correction before the politicians got serious about resolving the last debt ceiling debate, in 2011. We have seen signs that the President, for one, would consider a market decline helpful in creating a sense of urgency, which doesn’t seem to be there so far.

One big shift in the public commentary has been the change from “this can’t possibly happen” to “this is what will happen/has to be done if it does.” The front pages today of both the New York Times and Wall Street Journal reflect this shift, which will also contribute to a change, at some point, in the view the markets are taking. With the stock markets down since mid-September, and with fairly wide bounces the past couple of days, it may be that the markets are finally starting to price in the risk that politicians in DC really are that crazy—or that, even if the intention is to do a last-minute deal, something could go wrong.

Apparently, discussions have started within the Treasury again—and I expect have been underway for some time—about how to mitigate the worst of the consequences. Again, it’s highly likely that the consequences could be managed for a while, but there’s no doubt that if the U.S. government actually runs out of money to pay its bills, a line will have been crossed that can’t be undone. The fact that we really have moved from “it can’t happen” to “how do we deal with it?” suggests that many in the federal government, who would know best, are becoming less hopeful.

The final piece of this discussion, which no one is mentioning yet, is the effect on the real economy. Even if a last-minute deal is cut, even if the stock market doesn’t sell off, we are already seeing reduced business confidence, weaker consumer spending, and what appears to be a somewhat weaker employment picture. These are short-term data points, and volatile ones, but in this case, that’s the point: they are exactly the indicators that would react first. Just as the extended fiscal cliff debate at the end of last year killed fourth-quarter growth, the longer this goes on, the more harm will be done to the economic recovery.

Hopefully, that will be the worst of the damage.

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