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The government shuts down, a debt ceiling default looms--so why hasn't the market panicked?
09/30/2013 11:26 pm EST
The U.S. government will “shut down,” barring last minute intervention by the ghosts of George Washington and Abe Lincoln.
In two or three weeks the United States government will hit its debt ceiling limit and nobody is negotiating with anybody to avoid a confrontation where Option 1 is a default on U.S. government debt that could send global financial markets into chaos and Option 2 is a U.S. constitutional crisis if President Barack Obama decides to ignore the debt ceiling.
The Italian coalition government looks likely to fall and the country is likely to No. 1 violate its promise to reduce its budget deficit this year to 3% or less and No. 2 to continue in a recession that now stretches back to 2011.
And the reaction to this turmoil in the financial markets? On Monday morning, in the first hours of a New York trading session that was the first time that U.S. financial institutions and traders could react to the weekend’s news, the yield on the U.S. 10-year Treasury actually fell—meaning that the bond rose in price—by 0.01 percentage point to 2.61% as of 9:30 a.m. New York time.
And while stocks were down 2.06% in Tokyo over night, as the trading day moved towards the source of news in Rome and New York, the damage got progressively smaller. Stocks in Milan were down just 1.33% as the trading day there moved toward a close on Monday. And Monday morning as of 10:30 a.m. New York time the Standard & Poor’s 500 was off 0.51%.
That’s panic? Nah, that’s ho hum.
So why are the markets acting so blasé? How long might that collective shrug last? And what’s going on under the surface that might suggest a deeper anxiety?
First, the markets don’t think that a shut down of the U.S. government is a very big deal. Everyone understands that a “shut down” will leave much of the government operating—Social Security checks will go out and air traffic controllers will work without pay. As long as the shut down is of limited duration—a couple of weeks at the outside—no big deal.
Second, perverse as it may be, bond traders see a limited shut down of the U.S. government as a plus for U.S. Treasuries. The theory is that a government shut down and the resulting reduction in U.S. economic growth pushes off the day when the Federal Reserve will begin to taper off its $85 billion in monthly purchases of Treasuries and mortgage-backed assets. A short shut down would take the possibility of an October decision to begin a taper off the table and might even push a December taper toward the realm of the unlikely. From this perspective the recent rally in U.S. Treasuries that has taken the yield on the 10-year Treasury down to 2.59% is a continuation of the post-September 18 rally in Treasuries when the Fed didn’t take action on a taper.
Third, there’s still a large element of denial. At an extreme, the markets want to deny that Italian Prime Minister Enrico Letta won’t be able to put together the votes to win a confidence vote in the next few days or that the Republican leadership in the House of Representatives won’t decide to let Democrats and a few Republicans pass a clean continuing resolution. More traders seem to believe that whatever bad does happen won’t be in effect for very long. (Over the weekend in Italy the government of Prime Minister Letta moved to the edge of collapse after allies of Silvio Berlusconi said they planned to quit the coalition government. Berlusconi’s conviction on a criminal charge of tax fraud leaves him open to expulsion from parliament and Letta has refused to block those proceedings. So far Italian president Giorgio Napolitano hasn’t dissolved parliament or called for new elections but that seems just a matter of days with Letta saying he plans a confidence vote in parliament on October 1 or 2. Letta’s government would probably lose that vote without the support of Berlusconi’s People of Liberty party. Yields on Italy’s 10-year bond were up 0.13 percentage point last week to 4.42%.)
And, fourth, institutional investors calculate that as long as the turmoil in Washington and Rome doesn’t get too intense or go on for too long, it’s cheaper to hedge bets with derivatives such as credit default swaps on U.S. or Italian debt than to actually liquidate positions. No need to actually sell Treasuries or U.S. stocks if “insurance” in the derivatives market stays cheap enough.
If those are the reasons for the market’s very muted reaction to the current news coming out of Rome and Washington, D.C., then I get this framework for projecting how markets will react going forward.
The market is currently only pricing in limited damage from a government shutdown in the United States and that some kind of political patch job will emerge in relatively short order in Italy (after considerable pressure from the European Central Bank, the International Monetary Fund, and the European Commission.)
Which, of course, means that a U.S. shutdown that goes on for more than a couple of weeks isn’t priced in. Nor is a shutdown that runs into a bloody battle over raising the debt ceiling. I think global markets will show a much bigger reaction if the shut down battle looks like it is leading to a heightened likelihood of a confrontation over the debt ceiling that might lead to some measure of a U.S. default. (In the case of Italy, if negotiation fails and the country proceeds to a snap election that produces an even less stable coalition or, worse yet from the point of view of the financial markets, a victory for Berlusconi’s People of Liberty Party after a campaign promising no new taxes, then I think you’ll see the price of Italian bonds fall and yields climb significantly.)
And so does the price of insurance. At the point where it gets too expensive to buy a derivative to insure against a big move downward, the incentives for selling go up dramatically.
The problem in gauging the cost of credit default swaps on U.S. government debt is that the market is relatively thin. After all who would think they need to buy insurance on the debt of the world’s largest economy and instruments that trade in the world’s deepest market?
Still, on Friday, the price of credit default swaps on U.S. Treasuries had climbed to 32 basis points. That’s the highest since May.
Last time the U.S. markets went through this—back at the time of last debt ceiling battle in the summer of 2011—the price of a credit default swap on U.S. Treasuries climbed to 62 basis points. (That was the highest since the global financial crisis. What it means is that an investor would pay 62,000 euros a year to insure 10 million euros of U.S. Treasuries against a default in the next five years. The contract is denominated in euros to offset the impact of a default on the U.S. dollar.)
So you can see that we’re still a good way now at 32 basis points from the 62 basis points of the summer of 2011.
But the price is rising. And not just for U.S. debt. The biggest impact of the turmoil in Washington may fall on developing economies such as India or Indonesia with current account deficits and sagging growth rates. Credit default swaps on Asian debt (outside of Japan), as tracked by the Markit iTrax Asian index, had climbed to 155 basis points as of Monday. That’s the highest level since September 4 and at this level insuring this debt costs about five times as much as insuring U.S. Treasuries against default.
So where do markets go from here?
To a large degree that depends on events in Washington and Rome—and market interpretation of those events. If these two crises stretch out or worsen, then, duh!, markets will get more nervous. Reaction, I think it’s important to point out, will not be linear. Markets are likely to ignore gradually worsening scenarios with just minor declines until—wham--the duration gets too scary or the price of insurance goes too high.
A rule of thumb might be that risk of something blowing up in the markets goes up at twice (?) or more (squared?) the actual increase in duration.
And while you’re keeping an eye out for a possible big move in the U.S. or European markets don’t neglect the effect of these two crises on currencies and emerging stock markets.
The Japanese yen has again emerged as the safe haven of choice. That has sent the yen up and Japanese stocks down. Since the Abe government’s program to stimulate the Japanese economy depends on a weak yen, this move upwards isn’t good news for Tokyo equities. I wouldn’t necessarily sell Japanese stocks here since the bounce back when the yen again weakens is likely to be strong and a big new tax credit goes into effect in Japan on October 1 that gives Japanese investors tax free gains on up to $10,100 in annual investments as long as individuals invest in equities and equity-like instruments. My strategy here might be to instead buy on weakness sometime in the next week or two.
Emerging stock markets are likely to be very volatile during the U.S. budget and debt ceiling battles. (Remember that rising fear tends to send money into U.S. Treasuries even when the United States is the source of the fear.) I would frankly stay out of the most exposed emerging stock markets—India, Turkey, and Indonesia to name three—until this mess in the United States has subsided.
In Europe I’d watch for the Italian crisis to reverse the recent optimism about European economic growth.
Interesting times. Which isn’t a good thing in my book.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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