FYI | Sep 26 2013
By Kathleen Brooks, Research Director UK EMEA, FOREX.com
The next four weeks are a critical test for Washington: will they avoid a government shutdown and the first even US credit default or not? First up is the budget tussle. This time next week the US may have stopped providing all but essential public services, if the US Congress cannot agree on a budget to finance the government spending programmes for the next fiscal year. In the US the fiscal year starts on October 1st and ends September 30th. Right now there is no deal between the Republicans, who have control of the House of Representatives, and the Senate, which is controlled by the Democrats. The second fiscal hurdle on the horizon is debt ceiling. The self-imposed debt ceiling (currently at $16.7 trillion) will be reached by mid-October. If Congress does not agree to raise the limit then the US may enter its first ever credit-default.
We take a look at each event below and weigh up the financial market risks:
1, The US budget:
With only 5 days until the expiration of the current US fiscal year, politicians on Capitol Hill have yet to reach an agreement on the budget. The biggest bone of contention is Obamacare: the Democrats want to start funding it; the Republicans are bitterly opposed to it. The Republicans, who control the House of Representatives, have proposed a stop-gap measure to fund the government through to mid-December; however their deal would strip Obamacare of all its funding. The Senate, controlled by the Democrats, have said they will not accept any proposal to de-fund Obamacare, and are planning to amend the Republicans’ plan by proposing to fund the government through to November 15, and to fully fund Obamacare. The plan in the Senate is to hold an initial procedural vote on the budget plan at midday on Wednesday (ET) and to finalise its own budget plan by early Sunday, which would then give the Republicans 2 days to either agree with the Senate’s proposed budget or come up with amendments.
The Senate plan is causing outrage in Republican ranks. Firstly, they are concerned that 2 days is not enough time to digest and amend any Senate proposal. Secondly, there seems to be no middle ground regarding Obamacare, with both sides seemingly unwilling to compromise. Currently one Republican Senator, Ted Cruz, is staging a filibuster at the Senate (at the time of writing he has been speaking for nearly 24 hours) in order to block any passage of a bill by the Senate that includes provisions for Obamacare.
This tough stance of both the Republicans and the Democrats suggests that a budget plan will come down to the wire. But what would happen if the US government does shut down?
The practicalities of a government shut-down could see non-essential public services start to close early on Tuesday, with some 800,000 public workers potentially being sent home without pay until a budget deal is reached.
From a financial perspective, a government shut-down is unlikely to have too big a market impact and may not impact the US credit rating after Moody’s, the rating agency, said that it would not affect the long-term outlook for US public finances. Even though a government shut-down could erode the US’s political reputation this is unlikely to have an impact on the markets in the short term. Added to this, we would expect a government shut-down to be short lived and a temporary budget deal hastily arranged to cover government spending for the next couple of months in the days after any shut down.
Some have argued that a government shut-down could actually be good for the markets. Why? It may lead to a backlash against Republicans, who could be blamed for the shutdown, thus making the debt ceiling debate easier to resolve and potentially boosting risky assets.
2, The US debt ceiling:
This is much more important from a market point of view. If the debt ceiling is not raised and the US defaults on its debt for the first time in history, this would be a global financial problem as Treasury’s are considered the benchmark for the entire global financial system. If he market has no confidence in the US’s ability to pay back its debts it could cause a spike in volatility and a wave of risk aversion.
Back in 2011 there was a similar tussle in Congress regarding the debt ceiling. Back then the US eventually did decide to raise the level; however the price of Congress’s tardiness was a downgrade to the US credit rating and a 15% drop in the S&P 500.
The market has had to get used to tussles in Congress over the debt ceiling, so a decision to raise the ceiling, even at the last minute, may trigger a small relief rally in the markets. In contrast, the failure to reach an agreement could cause a market panic. Moody’s said it does not expect to change the US’s credit rating; however it also expects the debt ceiling to be raised. If it is not, then a rating downgrade may well be back on the cards.
On Tuesday another bomb shell was dropped, this time by the Treasury Secretary Jack Lew, who said that if the debt ceiling was not lifted by mid-October then the US coffers only have $50 billion left due to disappointing tax receipts this summer. This wouldn’t even cover 2 months’ worth of interest payments on US debt, yet alone the principle of maturing debt. It could also send Treasury yields soaring higher as the prospect of owning US debt becomes dramatically less attractive.
In the event that the ceiling is not lifted then the biggest market victims may be risky assets like stocks, commodities, commodity currencies and high yield debt. Even a short term shutdown could cause an echo in the market. The biggest beneficiaries could be gold, as an alternative store of value that is not controlled by any government, which may see a sharp rally, safe haven currencies like the yen and the CHF could also benefit, causing Japanese and Swiss officials (who have tried hard to limit the strength of their currencies) much distress. Ironically, it could also be good news for the US dollar, as the greenback is considered a safe haven because it is the most liquid currency in the world, and thus may attract some safe haven flow in the event of a US default.
The future of US fiscal issues: kicking the can down the road
Overall, it is tough to find any upside from failing to raise the debt ceiling, which could cause huge financial market ramifications. If deals are struck for both the budget and the debt ceiling, we believe any agreements will be temporary, thus kicking the can down the road to another struggle to reach an agreement in the future.
The ultimate problem is not that the US can’t afford to service its enormous debts, it can, but politics in Washington are increasingly dysfunctional. The Republicans are essentially split with the hard line Tea Party utterly opposed to Obamacare, which is literally drowning out (in the case of Senator Ted Cruz) the moderate wings of the party who may be willing to compromise with the Democrats.
Since mid-term elections are not scheduled until November 2014, these fiscal tussles could be a risk event for financial markets for some time yet.
Figure 1:
Source: Bloomberg
Figure 2:
Source: Bloomberg
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