For some weeks now I’ve argued that the US monetary taper is off again. Find below another excellent note from Westpac’s Elliot Clarke on why:
Two days out from the 17 October deadline, negotiations in Washington have (yet again) come to a halt. Key Senate figures had been working towards a compromise proposal, but those discussions stopped once news got out that House Republicans had rejected the plan without seeing any details, instead choosing to focus on their own initiative. If that wasn’t bad enough, it subsequently came to light that the House Republicans may not even have enough support to get their bill through the House, let alone the Senate. That this is the case has since been confirmed, with the Republican leadership cancelling a planned vote on the bill. There have since been some reports that the Senate has recommenced negotiations, but the House and Senate clearly remain miles apart.
We continue to see very little chance that a resolution will be found this week. Indeed, even if material progress towards a bipartisan agreement is made in the next 36 hours, the fractious state of the political status quo could delay a final agreement well into next week as opponents use any and all procedural delays available. This would take the length of the shutdown to over three weeks, and likely see Q4 growth reduced by around 0.5ppts in annualised terms to around 1% annualised, although the indirect impact of falling confidence of both business and consumers could have a much larger impact.
As we have repeatedly noted in recent weeks, 17 October is not the true deadline for non payment by the US government. At that time, the US Treasury will have around $30bn in cash on hand and, as estimated by the CBO, will continue to receive around $7bn per day in tax receipts which can also be used to fund outgoings. Rather, it is 1 November and beyond where the real risk lies. On this date, the CBO projects $67bn in non-interest payments will fall due, likely wiping out what cash is left on hand.
Markets have, broadly speaking, remained sanguine on the fiscal situation to date, arguably because of the timeline flexibility available as well as the general belief that common sense would (eventually) rule, as has been the case in the past. However, recent market developments provide evidence that the market psyche may be shifting.
Overnight, on news that negotiations had failed, the 1-month Treasury yield jumped from 0.15% to back around 0.35%, broadly in line with the 2-year Treasury yield. Further, Fitch revised its rating outlook for the US, changing it from stable to negative. As we highlighted last week, this is the first step towards Fitch downgrading the US from AAA to AA+ if a compromise cannot be reached. That decision would bring Fitch into line with Standard &Poor’s (S&P), leaving Moody’s as the sole provider of a AAA rating.
As we progress past 17 October, it is likely we will see a risk premium priced into more short-term yields and potentially (if this political malaise is not resolved in the coming fortnight) into longer-term yields. While not necessarily imminent, a downgrade by Fitch would add to market concern and speed any repricing process. And, as we move towards 31 October, the fear of missed payments will heighten market uncertainty.
On the latter point, Treasury Secretary Lew’s comments on the difficulties around prioritising payments in last week’s testimony are instructive. In response to a question on prioritisation, Lew noted “I do not know how you could make the decisions, I do not think the legal authorities are clear at all and I do not think the administrative process would permit the system to work”. He went on to note that “The systems are automated to pay… You cannot go into those systems and easily make them pay some things and not other things”. Clearly, once the Treasury’s cash reserves have dwindled, the entire payment process becomes akin to a lottery. Plausibly, the Treasury could be forced into a situation whereby they cannot pay any social security payments so as to make sure upcoming interest payments can be covered. Clearly this would have a material economic impact, not to mention the social and political implications.
The critical interest payment dates are 31 October ($6bn) and 15 November ($30bn). Moody’s and S&P have ruled that a default will only occur if interest payments are missed. Consequently 15 November becomes the critical date, with sufficient funds likely to be available on 31 October.
How the market will respond to such a scenario is unknown as we have never really experienced such an event. Equally, quantitative estimates of the economic impact of a debt ceiling breach based on historic data – on the CBO’s FY2013 numbers, immediately removing the deficit would reduce growth by around 4ppts in annualised terms, meaning activity would decline – also fail to tell the full story, missing out the indirect impacts associated with confidence (or a lack there of) and second round effects. Both the market and economic estimates then fail to communicate the real risks of this seemingly protracted shutdown.
But in closing, what should be of paramount concern is that we are now only talking about solutions that will run for but a few months, giving next to no certainty to investors, businesses and households. What it will take for Congress to agree to a year-long solution to this issue is completely unknown, as is how the US will right is long-term (material) fiscal concerns. In such an environment, it is difficult to understand how US growth can even maintain its sub-trend pace into 2014, let alone accelerate to the badly needed above-trend pace anticipated by fiscal and monetary authorities.
This is a worse outcome than I imagined but I think the reason that equity markets remain so calm is that this bad news is also good news. With only a temporary solution following already modest but material damage to the economy from the shutdown itself, the Fed is not going to be able to taper for the foreseeable future.
There is no way that the FOMC will be able to push the red button in its last few meetings this year as the economy slows and the drama drags into next year. We won’t know until then whether we’ll face more fiscal drag either. The data lags also prevent any move for the first few months.
Janet Yellen takes control in April and that’s perhaps the first opportunity but is she really going to press the button in her first meeting on the coat tails of near fiscal disaster? That puts us out to May at the earliest and probably later for certainty.
That’s far enough ahead that it’s ‘risk on’ in financial markets into the Congress gale. Sadly, it is no longer inconceivable that the Australian dollar goes back over parity, before retracing again.
