Markets are stumbling through October in the remarkable position where the creditworthiness of the US government is being called into question.
The first problem is that the government has been in partial shut-down since the beginning of the month. This is because a new government budget for the 2014 fiscal year, which runs from October 1 through September 30, has not yet been passed. This means that large portions of normal government services are not being delivered. This has a direct negative impact on US economic growth, but it is relatively modest (estimated to reduce annual GDP growth by around 0.2% for each month it continues).
The potentially bigger problem is that the US is projected to soon breach its ‘debt ceiling’, being the limit for government borrowing of a massive US$16.7 trillion that Congress agreed to back in February. Unless politicians agree to increase this debt ceiling, or suspend it as they did in May, the US government is going to run out of money within weeks.
October 17 is being seen by many in the market as “d-day” for the US government going broke. It is likely that they will be able to keep paying the bills for a bit longer than that, but only for a few weeks. Therefore, unless the politicians agree on a solution, we expect the US government will be forced to default on its debt by November.
This would be a calamitous event for global markets. US government bonds play a critical role in many areas of the global financial infrastructure. For example, they often serve as collateral for loans between institutions. Hence a default would force many types of funding markets to freeze up and would stress banking systems globally.
Further, references to treasury bonds are hard wired into vast arrays of financial contracts. As a result, once a default occurred, even if it was only temporary (meaning that the US government delayed interest and principal payments on its obligations for a few days until the politicians reached an agreement) there would be huge amounts of contracts that had to be unwound. It would be difficult to predict exactly how severe, and how rapid, the second and third round consequences might be for the real economy. But the impact would be clearly negative and as Ben Bernanke has pointed out, such a default could potentially trigger a global crisis more severe than that in 2008/09.
This picture raises several important questions about the effectiveness of the US political system. However it is important to note that we have been down this path before. The US has had a debt limit in place since 1917, and there is a long history of scuffles between Democrats and Republicans on this topic. In 1995 and 1996, under President Bill Clinton, the US government also shut down temporarily over a budget dispute. The US sharemarket actually made modest gains during this shut-down. Going back a further 20 years, to 1976, we find a further 14 government shut-downs.
More recently, in both 2011 and 2012 there were severe delays in approving a new debt ceiling. In August 2011 this led to a downgrade of the US credit rating by Standard and Poor’s, from AAA to AA+. That coincided with a downturn in Europe and August was a difficult month for markets, with the US sharemarket falling 5.7% and the NZ sharemarket by 2.1%. By comparison, the US sharemarket has already fallen by 2.7% since its recent peak in September.
If we look back over the last 20 years the debt ceiling has been increased 15 times. Going back 40 years, it has been raised 91 times.
So, despite markets’ frustration at the current attempts at political point-scoring in the US, we remain confident that sober minds will eventually prevail and a new debt ceiling will be agreed.
Indeed, overnight in the US there were positive signs that both Republicans and Democrats were offering concessions towards a potential compromise solution.
Such a solution would avoid the disaster-type scenario discussed above, and would be good news for stock market investors everywhere. As a result, the US markets have seen strong gains overnight.
However, we will also be focussed on the type of deal that is agreed. A short-term solution that buys only a couple of months’ time would be disappointing, as would a deal that led to a further material tightening in US fiscal policy. The timing of the deal is also important – if we have to wait until after October 17, expect investor nervousness and market volatility to pick up in the short term.