Tuesday, July 26, 2011

Debt Ceiling Deadlock: Why the Markets Don’t Seem to Care

The U.S. is inching closer to default, and in Washington the two sides are digging trenches whose depths rival the Mariana Trench. And yet the markets don't seem to care.

Over the weekend, both President Obama and House Speaker John Boehner insisted a deal needed to be completed before the Asian markets opened on Sunday afternoon New York time. Of course, the Asian markets greeted the lack of resolution with a collective shrug, as did the U.S. markets. On Monday, things only got worse, with a day of backbiting culminating in dueling prime-time speeches. And yet on Tuesday morning in New York, stock futures were up (although the market open mixed, with the Dow dragging close to 50 points) and the 10-year bond was trading at 3.00. Does that look like an impending crisis to you?

Many of my colleagues in the financial-political press seem to think we are about to see a repeat of the fall of 2008. Back then, amid market turmoil, the first Congressional vote on the TARP failed. But the horrific market reaction forced Congress to swiftly reconsider. The conventional wisdom holds that market turmoil forced Congress and the White House to bite the bullet and pass necessary, unpopular legislation. The presumption today is that only such market forces —- carnage in the bond market, a crash in the stock market, the hammer of a a credit agency downgrade -- will make Democrats and Republicans come together and strike a deal.

Don't hold your breath.

We're not supposed to say that it is different this time, but it is different this time. The 'markets,' to the degree that they have a mind, seem not to be too troubled by the debt-ceiling brinksmanship. Back in the 1990s, the common notion in Washington, popularized by Clinton adviser Robert Rubin and Federal Reserve Chairman Alan Greenspan, was that the bond market is like a crowd at a Roman gladiator match, signaling approval or disapproval of fiscal policy on a daily basis. But it clearly no longer serves that function.

Despite the hand-wringing about American decline and the constant refrain that the U.S. is the next Greece, the bond markets remain remarkably permissive. The U.S. government is currently borrowing for 10 years at almost exactly 3 percent, an extraordinarily low rate that is within spitting distance of a historic low. Look at the chart from the past six months. The Federal Reserve has stopped buying bonds, the political stalemate has worsened, inflation hasn't disappeared. And yet interest rates are contained. Why? As John Tamny and I discuss in the accompanying video, nobody really believes the U.S. government is going to default, even if it pierces the debt ceiling next week.

Nobody believes that the 10-year and 30-year bonds are not money good — i.e. they won't be paid off on time. This is emphatically not like the Lehman Brothers situation, when the world woke up one Monday and realized that $650 billion in debt was likely to be settled for pennies on the dollar. The government has revenues, and it has plenty of other people to stiff before it stiffs bondholders. In a time of turmoil and crisis, even when the crisis is over whether the government will pay its debts, the U.S. Treasury market is a safe haven. So don't look for it to be the fiscal enforcer.

As for the credit ratings, again, don't hold your breath. It would be an exceedingly bold move for S&P and Moody's to downgrade the U.S. sovereign credit rating. And, generally, these firms only act on sovereign credits after the market has made them look like chumps by driving up interest rates. If there has been a time in history when S&P downgraded a sovereign credit that was borrowing for 10 years at 3 percent, I'm not aware of it. Despite their desire to get ahead of the curve, the ratings agencies won't act until well after the market does.

What about the stock markets? Here, too, people hoping that a swift downdraft will spur action are likely to be disappointed. It's an enduring truism that the Dow and S&P 500, and indeed the global markets, are some barometer of opinion about how the U.S. is doing. That made sense in the late 1990s, when the U.S. represented about one-third of the global economy and its stock markets represented about 50 percent of global stock market capitalization.

While the U.S. is still the world's largest economy, global markets don't care so much about what happens here as they used to. Assuming the debt brinksmanship leads to a slowdown in U.S. growth, it won't put much of a crimp in Asian stock markets. The U.S. today is about 25 or 26 percent of the global economy and, more important, accounts for only a small sliver of the world's growth. As the rest of the world trades more with each other and less with the U.S., America has less ability to impact the trajectory of global growth. And if you believe the markets are rational and constantly factor in known data, well, sluggish U.S. growth and political dysfunction aren't exactly news.

Perhaps it is more surprising that the U.S. stock market has held up well in the face of this brinksmanship. And indeed, it's more likely that effects of a stalemate would be felt in the stock market than the bond market. Why? Huge deficit cuts, and a suspension of delay in the payment of salaries, benefits and entitlements would contribute to a demand shock, slowing growth (good for bonds, bad for stocks.) It could be that stock investors aren't watching cable news 24/7. But here, again, there's a sense that Washington, and even the U.S. economy, matters less and less with each passing day. Consider this: The typical member of the S&P 500 already gets about half of its revenues (and probably most or all of its growth) from overseas. The bigger the company, the less tethered to the U.S. Consider Intel, McDonald's, Coca-Cola, Apple; their earnings reports show that they are being driven by growth overseas.

If Washington is going to act on the debt ceiling and the long-term deficit, it will have to do so out of its own volition and sense of responsibility —- and not because of the savage demands of the credit and stock markets. Get ready for a few more weeks of brinksmanship.

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