With the U.S. government shutdown on its tenth day, there is still no political compromise in sight. So far, the markets have taken things in stride, but that’s simply because they’re waiting for the main event. Which won’t be long now. Barring an end to Washington gridlock, Credit Suisse now expects the government to run out of cash on Oct. 25. If a deal isn’t in the offing by next week, investors are in for a rough ride.
On Oct. 17, the U.S. Treasury will run out of emergency measures that allow it to keep borrowing money. Republicans and Democrats are reportedly considering a short-term increase in the debt ceiling, but if they can’t come to an agreement, the Treasury’s options will get downright surreal. Selling off the country’s gold reserves? Choosing which debts the world’s largest economy will pay and which it won’t? It is by no means clear what will happen if “Debt Ceiling D-Day” actually arrives, but one thing seems certain: the markets are going to start panicking sooner rather than later.
Sadly, the political brinksmanship seems likely to prevail until the last possible minute, Credit Suisse’s Head of Public Policy Americas Strategy Joseph Seidel said on a conference call with investors Monday. House Republicans, who have been holding out for either major changes to the Affordable Care Act or a one-year delay in implementing the law, have a number of lesser objectives that they might settle for in a deal to renew government funding by raising the debt ceiling. The two most likely options: the repeal of an ACA-related tax on medical devices and the approval of the Keystone XL pipeline. But even if the Republicans can bring themselves to back down from their larger demands—and they’re still insisting that they won’t—it’s not clear that the Democrats would budge from their own position that the raising of the debt ceiling not be subject to political negotiating whatsoever. Neither side is going to make this easy.
Finding a resolution before the country runs out of cash will probably take an inspired “mini-deal” with some modest provisions that both sides can point to as a victory, said Seidel. That could include modest reforms to taxes or entitlements to appease Republicans, combined perhaps, with some modest revenue-raising items for Democrats. In the meantime, here’s a roadmap for investors as we head closer to “D-Day.”
Fixed-Income Markets Pricing In Default Risk
On Oct. 17, the government will only have about $28 billion cash on hand – far less than its typical range of $50 billion to $150 billion and also well south of the $60 billion tab Treasury Secretary Jack Lew has said the country can run up in a single day. Money will keep flowing in and out of the national coffers, but without further borrowing, someone isn’t going to get paid.
Investors in longer-dated Treasury notes aren’t panicked yet, with yields on 10-year paper up only 0.02 percentage points since the first day of the shutdown on Oct. 1. But signs of stress are appearing in other corners of the fixed-income markets. Judging from the credit-default swaps that insure against defaults on U.S. Treasury bonds, investors are pricing in a roughly 3 percent chance of a default, a probability Credit Suisse analysts have described as “non-trivial.” That may seem like a pretty low probability, but it’s the change in that probability that matters. The spread on a 1-year swap contract has more than tripled from 0.85 percent on Sept. 20 to about 2.8 percent last week. In a recent note, Credit Suisse’s interest rate strategists noted that short-term T-bills are also starting to feel pressure from nervous investors. “The recent 1-month T-bill auctions have gone progressively more poorly, with (Tuesday’s) stop of 35 basis points up from 1.5 basis points two weeks ago,” they wrote in a note this week called “Short-End Tremors.”
Investors are due interest payments of about $6 billion on $862 billion worth of bonds at the end of this month. But that’s nothing compared to the face amount of Treasury bonds maturing on Oct. 24 and Oct. 31—some $90 billion and $93 billion, respectively. “They’ve been bouncing around quite a lot on very low volumes,” said Credit Suisse’s Ira Jersey, a director on the U.S. Interest Rate Strategy Team. “Liquidity has been very poor in those spaces – sometimes bids are not to be had.” The only way to make those redemptions, said Jersey, will be to issue matching amounts of new debt. This may come as a surprise to many, but the Treasury will still be issuing new debt in coming weeks, provided that the total amount outstanding remains below the $16.7 trillion limit. Auctions of a variety of Treasuries, ranging from T-bills with maturities of less than a year to 7-year notes, will take place in the last week of the month, with all of the securities settling on Oct. 31, which is also when they begin to count toward the debt ceiling.
The Treasury could potentially adjust the amount and maturities of new issuance to stay below the debt limit, Credit Suisse said, perhaps by cutting T-bill issuance while holding the flow of longer-dated bond offerings steady. Even so, Jersey said, “It’s going to be very difficult to make all the payments on Oct. 31. And even if you can make all those payments, it’s unclear how Social Security payments would be made on Nov. 1 and 4.”
Equities Markets Poised for a Breakdown
Seidel said that a stock market nosedive would go a long way to hurrying politicians along. And while markets have started to react to the logjam, equities investors have not yet been sending a crisis message, according to Khoa Le, Credit Suisse’s Co-Head of Flow Equity Derivatives. Since the beginning of the month, when the shutdown began, the S&P 500 has dropped about 2.3 percent, while the Dow Jones Industrial Average is down 2.6 percent.
Le explained that hedge funds have actually reduced their market exposure and are hedging more right now than they have all year. And he thinks that the market is holding steady only because corporations such as Apple, Microsoft and Goodyear Tire & Rubber have been buying back their own shares. “The market looks like it’s supported, and it rallies intraday when the U.S. opens, even if futures are down overnight,” he said. “It’s really all driven by corporate buybacks.”
The start of earnings season this week may mark the beginning of a slide in stocks. For one thing, many corporations enter a blackout period on share repurchases before and after reporting earnings. Le also thinks that corporate quarterly results are likely to be lackluster, which should also dampen market enthusiasm. “We definitely see a lot of data that consumers slowed down their spending, and we expect that performance is going to translate through into earnings,” Le said. “Once you pull out the support level from the corporations, start adding in some bad news from earnings and add on top of that that we’re going to run out of money come the 25th – in about a week, people are going to start panicking.” Indeed, Le said that if there is no debt ceiling solution by next week, the market is poised for a “mini-disaster” in equities for which most investors are ill-prepared.
What If the Unthinkable Happens?
The markets will shudder, but what will happen in Washington if there is no deal before Oct. 25? Credit Suisse sees a few options and laid them out in the bank’s most recent interest rate strategy note. First, the President could simply ignore the debt ceiling and order the Treasury to keep issuing debt above the $16.7 trillion limit. That very well may be illegal and such a move would likely end up before the Supreme Court. The government could also simply choose to pay for certain things – such as payments to bondholders and defense spending – while ignoring others, such as the senior citizens who rely on Social Security and Medicare. While unappetizing, that option would probably jolt Congress enough to force a quick resolution, the strategists said. The U.S. could also choose to default on some debts. But the prospect of the keeper of the world’s reserve currency defaulting on any portion of debt long considered a safe haven has such devastating potential for global financial markets that it does seem unlikely—if not necessarily impossible—that it will come to that.
There are less obvious solutions, too. For one, the Treasury could take steps to sell the country’s gold reserves. Former Treasury Secretary Tim Geithner rejected that tack in 2011 because it would send a signal of absolute dysfunction to financial markets. But as Credit Suisse pointed out in its interest rate strategy note last week, “faced with a choice to either fail to pay someone or to liquidate gold holdings and make everyone whole, Secretary Lew could conceivably argue that it is in the best interest of the public to sell gold in order to avoid jeopardizing the United States’ credit.” There’s even been a suggestion in the past of minting a $1 trillion platinum coin and depositing it at the Fed to beef up the asset side of the government’s ledger. The Treasury and the Federal Reserve ruled that option out during the last debt ceiling go-round in 2011, and Credit Suisse noted that even if the Treasury were secretly considering it this time around, “the Fed’s apparent unwillingness to accept such a coin means that even if minting such a coin is legal, it might not do any good.” In other words, it probably won’t happen this time either.
Finally, there’s an outside-the-box idea that may actually be possible. The Treasury could issue debt with a high coupon – say a 10-year note with a 10 percent yield. The debt would trade around $160, Credit Suisse said, so the government could theoretically issue debt that would only add $21 billion to its liabilities, but generate almost $34 billion in sales. That, of course, would punt enormous interest payments onto future generations – but that’s something governments everywhere are used to doing. “In a worst-case scenario, we think this is the solution that would be the least ‘ridiculous’…and have a less damaging impact on confidence,” analysts wrote. The closer we get to “D-Day,” too, even the ridiculous might actually be welcome.
Photo of House Speaker John Boehner by AP Images/Evan Vucci.