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What-Ifs for Wall Street on Debt

The opinions expressed by columnists are their own and do not necessarily represent the views of

More debt limit plans have come out but they didn’t resolve anything.  expected, the dollar has been weak with gold closing at a new record high of $1615 per ounce.   Later this week, we expect the Administration to announce the sequencing of the shutdown in payments (for example, student loans).  
  • Treasury Secretary Geithner had pushed Congressional leaders hard over the weekend for progress on the debt limit on the idea that financial markets would react badly on Monday unless there was a deal.  We’re skeptical that markets will provide much leverage or take sides. In general, financial markets have seemed glad the U.S. is fighting this battle now -- markets held up much better in the 2011 soft patch than the 2010 soft patch, with equities near a post-2008 high.
  • Most of the remaining scenarios for the debt limit increase are mildly market positive because they involve spending cuts and no default.  Financial markets won't be too picky about the size of cuts (the more the better) or when a deal gets done (any time is fine as long as there's not a risk of default on Treasury debt.) The dollar is mostly affected by the Fed’s very weak policy versus other central banks, which keeps gold prices rising and the dollar in a harmful downtrend in almost all debt limit outcomes. 
  • Financial markets are tuned to corporate profits, GDP growth, innovation and a country’s actual structural reforms (not smoke and mirrors).  Since the debt limit negotiations have been aimed mostly at one-off accounting adjustments rather than a new system of spending restraint – more like the budget-balancing efforts in Minnesota and New York where no wages, jobs or programs were cut yet billions of savings were claimed – there aren’t many ways Washington can disappoint already low market expectations.  The only deeply negative scenario is a default on Treasury debt, which all parties say isn't going to happen.  The only deeply positive scenario would be for Washington to change the spending process to provide restraint, not under discussion. 
  • We think financial markets would take a debt downgrade in stride (though it would be costly for some corporate and state borrowers tied to the U.S. rating.)   We expect one or more of the bond raters to lower the U.S. AAA sovereign rating, but they may wait until after the debt limit increase is over and the dust settles to avoid being criticized for making the crisis worse.  We expect bond yields to rise once the debt limit is increased regardless of the amount of deficit reduction or the bond rating.
In the end, we expect a payments shutdown to force a debt limit increase, with no default and continued rapid growth in federal spending and debt.  Here's a list of possible outcomes from worst to best and our view of the market reaction.  In the first three cases, we think there would be a bond rating downgrade. 
1.                  Default, meaning principal or interest payments not made on time. If this happens, it's catastrophic.  Markets depend on timeliness and contract law.  A default is fraught with unintended consequences like the Lehman bankruptcy was.  It means that Treasury somehow can't or won't prioritize payments to avoid default.  This permanently reduces the value of "full faith and credit" obligations.  Equities fall a lot.  The dollar would strengthen at least temporarily due its safe-haven status.
2.                  No deal this week so the White House sets in motion a shutdown in various payments.  We think this scenario is quite possible and would be a mild negative for equities due to the continued uncertainty about whether the U.S. is able to make any spending cuts at all.  Dollar weakens.   
3.                  One-step increase in the debt limit based on spending cuts.  Today, Senate Majority Leader Reid and Sen. Schumer propose $2.4T in debt limit for $2.7 trillion in spending cuts.  However, the spending cuts including $1 trillion in savings from winding down the Iraqand Afghanistan Wars (savings that would occur any way) and $400 billion in “interest not paid on debt not incurred.”  We think this scenario would be only mildly equity market favorable.  It gets the debt limit done through 2012, but the spending cuts don’t provide any sense that the U.S. intends to make structural reforms.  Dollar weakens. 
4.                  Two-step increase in the debt limit based on spending cuts.  Today, House Speaker Boehner proposed $1 trillion in debt limit for $1.2 trillion in spending cuts, then another $1.6T in debt limit if agreement on an additional $1.8T in spending cuts is reached late this year.  This is akin to the “mini-deal” we described in our July 11 piece. As long as the spending cuts aren’t all smoke and mirrors, we think this scenario would be equity market favorable.  It leaves open the possibility of actual spending reforms later this year.  Dollar weakens due to Fed policy.
5.                  None of those scenarios is constructive for the U.S. growth outlook.  We think they should instead replace the current debt limit (which is harmful because it threatens default but doesn’t control spending) with a debt limit enforced by spending cuts rather than debt default. (See my February 1 Senate testimony on this and articles in the WSJ, ForbesWashington Times, NY Sun and  The current debt limit forces a choice between default and more debt.  Keeping the current debt limit intact isn’t a viable option because it has to cover past spending, the ongoing deficit, and the trust fund buildup.  This forces a sweeping and damaging payments shutdown until the debt ceiling is raised.  Instead, we should have a permanent debt-to-GDP ceiling which penalizes Washington (both Congress and the Executive Branch) when above the debt ceiling, requires the president to propose spending cuts and gives the president impoundment authority (to underspend congressional appropriations).  A structural reform like this would have a very positive impact on the U.S. private sector outlook and financial markets and could be dollar positive if accompanied by Federal Reserve policy changes. 


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