Debt Cloud Hanging Over the Markets

The political debate over raising the US debt ceiling is likely to add to the dog days this summer, but despite the chest-beating and vitriol, Congress has little choice but to make a deal, writes MoneyShow editor-at-large Howard R. Gold.

Stocks had a rough month in May and have continued to struggle in June. The S&P 500 index closed lower for five consecutive weeks through last Friday.

The pundits blame it on the imminent end of the Federal Reserve’s quantitative easing (QE2) program, and renewed worries over the weak links in the Eurozone—Portugal, Ireland, and most of all, Greece.

QE2 is being phased out just as the economy weakens again, but investors have anticipated the program’s end for weeks. And European countries are preparing a new fix for Greece’s debt problem.

The US is another story, and that’s where the next big hurdle for this market may come.

As QE2 ends, the debate over an increase in the debt ceiling will move to center stage. Dire warnings and brinkmanship from both parties will fill the headlines, airways, and blogosphere this summer, showing Washington at its worst.

Investors, already worried about the struggling economy, will be biting their fingernails as they wait to see whether the US government will default on some of its obligations.

That ugly process is likely to be bad for stocks in what’s already the worst period of the year from a seasonal perspective. But a timely agreement between Democrats and Republicans—which seems remote now—could spur a rebound. The failure to strike a deal could have the opposite effect, of course.

“The rhetoric will get more confusing over the next few weeks, and markets hate uncertainty,” said Greg Valliere, chief political strategist of Potomac Research Group. He thinks a deal ultimately will get done.

$14.3 Trillion Buys a Lot of Rubber Stamps
The stakes are high. The debt ceiling is an agreed-upon cap on the amount the US Treasury can borrow. Congress has raised the debt limit 74 times since 1962 so the federal government can meet its obligations.

Usually it’s just a rubber-stamping exercise. But this time, a Republican-controlled House of Representatives—which swept into power on the back of the Tea Party movement—is preparing to take a stand against too much federal spending, and they’ve picked the debt ceiling as their battleground.
Valliere called the 87 freshman Tea Party House Republicans “unlike any group I’ve ever seen in my career. These people don’t give a damn about being re-elected. They feel they are on a mission from God to cut spending,” he told me.

The debt ceiling sits at $14.3 trillion, which the US already exceeded in May. Secretary of the Treasury Timothy Geithner has said the country will begin to default on its obligations if the ceiling isn’t raised by August 2, setting the stage for the battle ahead.

“If Congress failed to increase the debt limit, a broad range of government payments would have to be stopped, limited or delayed, including military salaries and retirement benefits, Social Security and Medicare payments, interest on the debt, unemployment benefits, and tax refunds,” Secretary Geithner warned in an April 4 letter to Congressional leaders.

“Default would cause a financial crisis potentially more severe than the crisis from which we are only now starting to recover. For these reasons, default by the United States is unthinkable.”

Wall Street, taking a break from its denunciation of financial reform, is standing shoulder to shoulder with the administration on this one.

Jamie Dimon, chairman and chief executive officer of JP Morgan Chase (NYSE: JPM), said recently: "If anyone wants to [cap the debt ceiling], which I think would be catastrophic and unpredictable, I think they're crazy."

Next: Warnings from China and the Rating Agencies

Another Chase official, managing director Matthew Zames, warned in more measured tones: “Any delay in making an interest or principal payment by Treasury, even for a very short period of time, would put the US Treasury and overall financial markets in uncharted territory, and could trigger another catastrophic financial crisis.”

And so on:

• The US Chamber of Commerce also has called for Congress to raise the debt ceiling “as expeditiously as possible.”


• Standard & Poor’s already has put US government debt on CreditWatch with negative implications.


• Last week, Moody’s Investors Service “warned it would consider downgrading its rating for the US unless progress is made in the coming weeks on an agreement to raise the debt cap, because of the low but increasing risk of a short-lived default,” The Wall Street Journal reported.


• Fitch Ratings followed suit Wednesday.


• And as if to add insult to injury, Li Daokui, an advisor to the People's Bank of China, urged Congressional Republicans on Tuesday to “stop playing with fire” and extend the debt limit. China, of course, is the largest foreign holder of US Treasuries, with $1.1 trillion in holdings as of March—more than 7% of total US Treasury debt outstanding.

The GOP deficit hard liners have plenty of defenders. Former hedge-fund manager Stanley Druckenmiller told the Journal: "I think technical default would be horrible...but I don't think it's going to be the end of the world. It's not going to be catastrophic. What's going to be catastrophic is if we don't solve the real problem."

He’s supported by 150 leading economists, including conservative luminaries like John Taylor of the Hoover Institution, Nobel Prize winner Robert Mundell, Allan Meltzer of Carnegie Mellon University, Michael Boskin of Stanford, and former Treasury Secretary George P. Shultz.

“An increase in the national debt limit that is not accompanied by significant spending cuts and budget reforms would harm private-sector job growth and represent a tremendous setback in the effort to deal with our national debt,” they wrote.

History Shows a Deal in the Making
A similar battle took place back in 1995-96 between a Republican-controlled Congress and President Bill Clinton. Moody’s and S&P put hundreds of billions of dollars of US government bonds under review for a possible downgrade.

According to Druckenmiller, "’the bond market rallied throughout the period of the so-called train wreck . . . and, by the way, continued to rally. Interest rates went down the whole time, past the government-shutdown deadline.’”

But this time, the stakes are a lot higher, because the numbers are a lot bigger. There’s more worry about the sovereign risk of US Treasuries in general. And the economy then was booming, unlike today.

That’s why Valliere thinks the debate will go on until the last minute—late July or early August— and then ultimately result in a deal.

“We’re not going to default. Chances of default are no greater than 5%,” he told me. “I think at the end of the day the adults will prevail.”

Republicans will get their pound of cuts—maybe as much as $1.5 trillion from discretionary domestic spending over ten years, he predicted. “What you’re not going to get is anything on entitlements” this time around, he said.

And when we have a deal, “I do think there will be a relief rally, and I think the deal will be tougher than many people expect,” he said.

Until then, this is likely to be yet another obstacle for a market that looks as if it’s run out of gas.

Howard R. Gold is editor at large for MoneyShow.com and a columnist at MarketWatch. Follow him on Twitter @howardrgold and read more commentary on www.howardrgold.com. He blogs about politics on www.independentagenda.com. Read Howard’s blog post on the battle over Medicare here.