Outside the Beltway

Are The Markets Starting To Notice How Messed Up Things Are In Washington?

Signs that investors are starting to get nervous about the lack of action coming out of Washington.

Doug Mataconis · Tuesday, October 8, 2013 · 17 comments

So far at least, the response of investors on Wall Street to the ongoing government shutdown, and the impending breach of America’s debt ceiling, has been rather muted. For the most part, financial analysts say that this is largely because professional investors believe that they’ve been through this before and that, in the end, Congress and the President always end up coming up with some kind of deal in the end. The longer the shutdown lasts and the closer we get to the debt ceiling deadline (according to CNN’s handy dandy countdown clock we’re just over 200 hours away from that event), the less likely those self-assurances are likely to sound, and the more likely it is that we’ll see Wall Street start to react negatively. Perhaps then, everyone in Washington will finally start taking this seriously.

Over at The Washington Post, Neil Irwin thinks  he sees signs that Wall Street may be waking up the what could be a new reality:

A lot of the market indicators of how much the financial world is worrying about a debt default have been quite calm over the last week. The Standard & Poor’s 500 index, for example, is only about 1 percent below its close eight days ago, when the government shutdown began.

But in the less widely followed — but in many ways more important — market for Treasury bills, things are starting to get scary. These are short-term IOU’s of the U.S. government, bills issued for 30, 60 or 90 days. They enable Uncle Sam to manage cash flow much the way a homeowner might use a credit card. They also form the backbone of trillions of dollars in transactions: Major corporations and banks use them as a place to park short-term cash; they are held by money market mutual funds; and they serve as collateral for millions of transactions in markets around the world.

Normally, the interest rate the government pays on bills is around the same as the short-term interest rates in other money markets (for example, the interest rates banks charge each other for overnight cash, or the interest rate that the Federal Reserve targets). Both of those are near zero right now, which is why on Sept. 30, eight days ago, the interest rate on Treasury bills maturing Oct. 17 was a mere 0.03 percent. Nothing, in other words.

But since then, the possibility that the Treasury might have trouble paying or might not be able to pay its bills over the next few weeks has grown — and the interest rate has skyrocketed. It was at 0.16 percent at Monday’s close. On Tuesday the rate so far has been almost double that, as high as 0.297 percent.

Irwin provides this chart for the T-Bills that will be maturing on October 31st:

Irwin also cites this report from Reuters that money managers, the people how manage money market and other funds for example, may be starting to avoid short-term U.S. debt because of the uncertainty starting to creep into the market:

(Reuters) – The $2.66 trillion money market industry is preparing for the worst as lawmakers in Washington battle over the U.S. debt ceiling.

The funds, including those run by PIMCO, Federated Investors Inc and the largest money fund sponsor – Fidelity Investments – are shying away from government debt that matures in the next few months and keeping more cash on hand to help them withstand any delays in the U.S. paying its creditors.

So far, investors have not been rushing to yank their money from the funds, as many still expect that Republicans will come to an agreement with Democrats over the nation’s borrowing limit and avert a default. The U.S. Treasury expects to exhaust all of its remaining borrowing capacity by October 17.

But if the United States fails to raise its debt limit and repay maturing debt, panicky investors may look to raise cash, in part by withdrawing from money market funds. The funds would have to find ways to pay back their investors, either with cash they have on hand or by selling assets. The industry could face one of its biggest tests since the financial crisis forced the government to provide emergency support to the industry.

It’s not hard to imagine that this could only be the beginning of a move by investors that could pose problems for the Treasury Department’s ability to raise short-term cash going forward. The closer we get to the Treasury Department’s “drop dead” date without a resolution of the debt ceiling issue, the more likely it is that uncertainty is going to creep into the money markets. In that instance, investors will either be less likely to participate in Treasury auctions, which will result in the interest rates on the bonds having to be raised in order to attract buyers, or they’ll demand higher interest rates in the first place. In either case, the impact will remain the same and higher interest rates will likely reverberate throughout the T-Bill markets and, if it lasts long enough, to the economy as a whole. Increased uncertainty could also lead holders of Money Market Accounts to begin pulling money out of their accounts, which would require fund managers to sell off more bonds in order meet the cash requirements they need to satisfy redemption requests. This was precisely the kind of scenario that nearly caused a collapse of money markets in the wake of the 2008 financial crisis.

The other possible reaction to the looming uncertainty coming out of Washington is that we’d see stocks and other non-Treasury investments decline as investors move their assets into safer investments. Ironically, even with the uncertainty that breaching the debt ceiling will inevitably create, that would likely include T-Bills, although it’s likely that in that case you’d see investors move to longer-term bonds on the theory that it would be unlikely that Washington would allow a debt ceiling breach to continue for very long. In that case, the real damage would be to 401k and IRS balances, which of course took a massive hit of their own during the 2008 crisis. In that case, the damage for bonds would be largely confined to the short-term market one would assume.

More broadly, CNBC observes that Wall Street analysts are reluctantly coming to the conclusion that this time things may not turn out okay in the end:

Wall Street experts, who only a few days ago dismissed a debt default as a near-impossibility, are now having to come to grips with a worst-case scenario that no longer seems so far-fetched.

Consensus opinion had it that Washington politicians, for all their partisan rancor, would never be so irresponsible as to allow the U.S. to miss even a debt interest payment.

But with both sides recalcitrant and no progress made in negotiations, strategists and economists are beginning to caution clients that the probability of default is rising.

“The likelihood of an amicable settlement of the looming debt ceiling deadline appears highly questionable,” Wells Fargo strategists Paul J. Mangus and Darrell Cronk said in a report.

“This is not to say that the winds of politics might not shift in the next two weeks, but the markets are becoming increasingly skeptical over the recent level of discord in Congress,” they added. “This suggests that, at least in the short-term, we can expect more episodic swings of market volatility than usual.”

The change in analyst tone may not necessarily be reflected in market behavior yet, but some dynamics are changing.

One-year Treasury credit default swaps—the cost of insuring U.S. debt—have seen prices surge, with Tuesday alone seeing a 10 percent rise. An auction for three-year notes Tuesday was mediocre, with the lowest demand since June.

Also, the CBOE Volatility Index, a popular gauge of market fear, gained more than 6 percent and eclipsed the 20 mark, considered a dividing line for significant levels of investor unease. The VIX had last breached 20 in June 2012 amid intensifying fears over the European debt crisis.

Equity market indexes such as the S&P 500 have been in a slow, orderly melt lower and seem to be waiting for a reason to rally.

At the same time, they continue to downplay the idea that we’re heading for catastrophe:

“Speculation that a limited default by the U.S. government would lead to a bigger financial and economic crisis than the collapse of Lehman Brothers is surely overdone,” Jessop said in an analysis. “The crucial difference is that the U.S. government would still be a going concern, with all the tax and spending powers of a sovereign state.”

Still, he said that doesn’t mean there would be no effects.

“While we continue to think that default will probably be avoided, it would be unwise to rule anything out,” Jessop said. “A prolonged period of uncertainty would clearly be negative for the global economy and for the prices of risky assets. Nonetheless, the bottom line is that the U.S. government is not Lehman.”

This much is true, although it’s worth noting that the U.S. Government only has “the tax and spending powers of a sovereign state” if Congress authorizes the same. If a debt ceiling debacle occurs at the same time that the ability of the Federal Government to tax and spend is hamstrung by even the limited shutdown we’re living through right now, it’s unclear what the consequences might be, or what kind of uncertainty might be introduced into the markets.

Whichever way the market reacts, though, it’s becoming rather obvious that there’s no way that there’s not going to be some damage inflicted by a debt ceiling breach, and that it’s likely to become apparent long before we hit the October 17th deadline that the Treasury Department has set. Considering that this date is now only nine days away, perhaps it’s only a loud and clear message from the financial markets that will cause Congress, primarily the Republicans, to act on the debt ceiling.