Debt Ceiling - How it affects the Market

WHY haven't financial markets been more perturbed by the dangerous game being played in Washington? There are plenty of explanations circulating, but we shouldn't ignore the most straightforward one, however unlikely it seems: because the game isn't that dangerous. Let's stipulate a few things before proceeding. The political mess in Washington is every bit as stupid (and, for an American, embarrassing) as everyone says it is. It has also already done its share of harm. The government is wasting the opportunity presented by dirt cheap borrowing costs to make valuable public investments and boost short- and long-term growth. If the government were dead set on slashing deficits there are vastly better ways of doing it than what has emerged through several years of disaster chicken. Foolish fiscal battles, and the Republicans' daft and doomed attempt to short-circuit Obamacare, have had an enormous opportunity cost, in terms of the legislation that might have been passedimmigration reform, tax reform, and so on but which has now been delayed by these antics and potentially sunk by the accumulation of bad blood. And the debt ceiling is a doomsday machine. If Congress actually did fail to authorise the issuance of more debt and the White House didn't come up with a work around then payment prioritisation for any length of time would mean dramatic and chaotic austerity sufficient to return the American economy to recession. And if the world actually did lose faith in American government debt as a safe asset the resulting financial -market chaos would be difficult to predict in its specifics but easy enough to imagine in its generalities. It's a terrible situation. But how much of this is new information? Surely markets have by now priced in deep Washington dysfunctionality, rapid fiscal consolidation, and even the new norm of debt-ceiling gamesmanship. Default, in the sense of not receiving the expected pay-off on a loan to the government, is always a risk in any country, including America. The question is whether perceptions of this risk have gone up. The answer is...sort of. Though Treasury yields have not moved very much on the whole in respo nse to the stand-off, yields on very short-term debt at durations of one and three monthshave moved up substantially. The cost of insuring American debt has also jumped over the past month. One has to assume that on some debt vintages expectations of default have risen at least a bit. But. The yield on the 1-year Treasury is essentially unchanged from where it began the year or where it stood a month or two ago. The dollar has been a rock. Inflation expectations have been stable. Equities remain close to all-time highs. One is forced to conclude either that default would not be a disaster at all, or that the kind of default markets think has grown likelier is nothing at all like the sort of default that would be a disaster. Felix Salmon, in a post arguing that America has already begun rolling off the cliff (or into the fire or whatever), explains what might be behind all of this:

[I]f you really do expect zombies to start roaming the streets the minute that the US misses a payment on its Treasury obligations, youre likely to be disappointed. Yes, the stock market would fall. But the price of Treasury bonds would remain in the general vicinity of par, and it might even go up if Treasury announced that past-due interest would be paid on all debt at a statutory rate of 8% per annum. Even when its Treasury bonds themselves which are the instruments in default, Treasury bonds remain the worlds flight-to-quality trade, and the expected recovery on all defaulted Treasury obligations would be 100 cents on the dollar or more.The harm done to the global financial system by a Treasury debt default would not be caused by cash losses to bond investors. If you needed that interest payment, you could always just sell your Treasury bill instead, for an amount extremely close to the total principal and interest due. Rather, the harm done would be a function of the way in which the Treasury market is the risk-free Vaseline which greases the entire financial system. If Treasury payments cant be trusted entirely, then not only do all risk instruments need to be repriced, but so does the most basic counterparty risk of all. The US government, in one form or another, is a counterparty to every single financial player in the world. Its payments have to be certain, or else the whole house of cards risks collapsing starting with the multi-trillion-dollar interest-rate derivatives market, and moving rapidly from there. Mr Salmon makes the true and important point that disaster would result when the realisation that Treasury payments couldn't be counted upon changed Treasury's status as a risk-free instrument. The trouble is that a status change has to be the disaster transmission mechanism because actual cash losses associated with "default" probably wouldn't materialise. But if no one thinks that cash losses will ever materialise then why should there be a status change? Default is supposed to be in a special category of obligation repudiation (as opposed to inflation, say) because it represents a clear red line being crossed. Markets panic over default in a way they don't over a rise in inflation from 1% to 3%. Defaults trigger credit-default swaps. And so on. But there are defaults and there are defaults. How would the Lehman bankruptcy have mattered if investors felt confiden t that, whatever payment interruptions occurred, Lehman debt would end up returning 100 pence on the pound? And if as a result there had never been a liquidity problem in the market for Lehman debt? What are the consequences of default if an investor never need worry about market liquidity and never need worry about lower-than-promised pay-offs? And why should markets' confidence that those conditions are unlikely to be upset be shaken? For all the Congressional drama, I'm not sure the probability of a big bang default has ever budged from anything other than miniscule. And if markets' confidence that those conditions are unlikely to be upset is unshaken, then why should any of this debt contretemps much matter? It will matter in some ways, of course. Financial activities that used Treasuries as if they were honest-togod risk-free assets might be disrupted. But if the American government were the platonic ideal of functionality its debt wouldn't be honest-to-god risk-free. There's no such thing. Changes at the margin are not nothing. But they may well be far less important in the scheme of things than any number of other rich-world policy choices from the past few years.

And that takes us to a final point. One might say: maybe Treasuries are highly liquid and maybe you never have to worry about losing money lending to the American government, but why put up with this kind of foolishness if you don't have to? Well, where else are you going to go? People say that American debt benefits from being the least dirty shirt as if that meant American debt weren't any great shakes. But being the least dirty shirt is a pretty big deal. The market for American government debt is larger than that for any other sovereign debtby a long shot. Japan is the only economy that comes anywhere close, and it isn't exactly an investor's dream when it comes to weighing up tail risks. After that there are sound-looking markets and unsound ones, but none are even a sixth of the size of America's. And America pays its debts in a global reserve currency backed by its own, independent central bank. Treasuries are simply special. Not so special that their status couldn't be altered by a significant enough event. But markets do not think that the odds of an event of that nature have risen. Hence the market calm. This may all read like hubris and complacency. I could be wrong; maybe debt-ceiling chicken is like Russian roulette and each harmless pull of the trigger brings disaster one step closer. I certainly don't wish to defend debt-ceiling hostage taking; it's reckless and stupid and there is always a chance of something going awry. And I certainly don't wish to imply that this all has been costless. If tomorrow Congress passed a clean continuing resolution and abolished the debt ceiling I suspect equities would have a pretty darn good day. But by focusing on the effects of the worst-possible-thing-that-could-happen without much regard to whether expectations of the WPTTCH actually occurring have changed, we may all have lost some perspective on the dynamic in Washington. Last time, a deal got done long before even a tiny, technical default was a remote possibility. And America then went on to continue to provide lots of nice Treasuries while also stabilising growth in public-debt-to GDP and managing decent (by rich-world standards) output growth and stable inflation. And kept on being innovative and open and dynamic in a way none of the world's other large economies manage. This time? Maybe, a week from now, zombies will roam the streets. But I'd bet my money on a deal getting done long before even a tiny, technical default becomes a remote possibility. Guardian: The bill passed easily with broad bipartisan support in the Senate, able to pass the Republican-dominated House shortly after 10pm only with the support of Democrats, It laid bare a rupture between moderate and more rightwing Republicans, who triggered the crisis by using their budgetary leverage in what turned out to be a futile effort to undermine Obama's signature healthcare reforms. On both sides of the Capitol building Republican lawmakers looked deflated after the votes, which capped a dramatic capitulation after weeks of brinkmanship with Democrats who refused to blink. House Speaker John Boehner signalled he was ready to accept a Senate -drafted peace deal that contained almost no concessions to the conservatives who had driven the country the precipice of a new financial crisis.

The deal, crafted by Reid and McConnell, will fund the government until 15 January and lift the debt ceiling until 7 February, setting the stage for a possible repeat of the showdown. Both sides also agreed to a formal budget conference in an attempt to reach a longer-term deal by 13 December. The bill also ensures the 800,000 federal workers who were furloughed for at least part of the shutdown will receive back pay. Several conservative members leaving the meeting conceded that the hardline Republican tactics had left them empty-handed. "We got nothing," said Thomas Massie, a Republican from Kentucky, who admitted his side had emerged with "a goose egg". Yet for the most part they rallied behind Boehner, who had sought to appease the restive conservative element until it was no longer feasible to do so. Recriminations among Republicans flew thick and fast, with moderates accusing House conservatives of trashing the party's reputation in pursuit of an impossible ambition to repeal or defund the Affordable Care Act, also known as Obamacare. Graham was scathing about the influence of conservative advocacy groups such as Heritage Action, which torpedoed a deal on Tuesday when it threatened to withdraw support from Republicans who backed it. He also warned of the damage that the party had inflicted on itself. It was one of the worst of all possible outcomes for Republicans. None of their stated goal s were achieved, and polls showed that voters overwhelmingly blamed them for the crisis. By refusing to blink, Democrats pushed Republicans to show that they would not let the US default on its debts, making it hard for the GOP to repeat its tactic. Tea Party congressional caucus, That view was not shared at the White House. As he left the lectern after his Wednesday night press briefing, the president was asked by a journalist whether the crisis would happen all over again in a few months. Speaking over his shoulder, Obama replied: No. No it could have messed up the financial markets all over the world. US treasuries are a baseline for risk. If they become unstable it reeks havoc. Higher interest rates Isn't this the same financial market that thought Lehman Brothers was a good bet? I'm not sure I'd trust them to make rational decisions any more than I'd trust Obama to be consistent or Republicans to use anything remotely resembling rational thought or logic. Supposing none of your suppositions materialize, America nontheless has been given a chance to learn the true face of the Teapartiers - anything but patriotic. I suppose that is worth quite a few dollars. Uncle Sam has long ceased to be terribly tall in the eyes of the world, thanks in great part to the antics of the Tea Party and their variety of delusions, since their ascendance. Who elected them? . Politics has never been clean and unmessy anywhere. But the Tea's have exceeded all conceivable limits.

The country will survive and carry on, including its monetary system, but not without damage at least to its own image and how it is perceived by folks in the rest of the world whose mental fodder does not consists entirely of fantasies and delusions. There are those in the country who are arrogant enough (assisted by their fantasies ) to say, "So what?" Well, so America has degraded itself. There is something called "esteem" even in international dealings. People can keep a straight face. But underneath it is pure scorn - that there exists this kind of hoodlumery in America.