Market Volatility Compresses As Debt Ceiling Looms
Volatility in stock, bond, currency, and gold markets continue to contract as they pause awaiting not only the next meeting of the Federal Reserve but also the resolution of the current political battle over the debt ceiling.
Depending on who is doing the talking, and what “extraordinary measures” are used by the US Treasury to shuffle money around, the US government will be close to running out of money in the next week or so.
Markets appear to act as if this threat is mostly political theatre, as none of the major markets are currently acting as if the US is really about to default on its sovereign debt.
For example, if the markets truly thought the US would not be paying interest on US treasury bonds, which is the reserve asset of the world as well as our own banking system, Treasury bonds should be falling sharply in value, discounting that these bonds could become worthless. Falling bond prices would translate into sharply higher interest rates, since the price of a bond and its yield, are mathematically connected at the hip. Such a collapse in price would harm everyone who owns them, which is most of the world.
Bonds, however, are only drifting gently lower right now. However, their decline over the past year is largely responsible for our serious bank failures of late.
Likewise, the value of the dollar should be falling sharply, roiling international trade and banking as well. That is currently not happening either. The dollar has been drifting lower of late but recently has bounced back up a bit. If we simply start to print money to pay all of our bills, that can hardly be expected to help the value of the dollar.
If the “reserve” of the international banking system were really about to default, then one would expect gold prices to be rising sharply. They aren’t. Gold, of course, is the only recognized international reserve, not an obligation issued by a government, and hence, can’t default. But of late, its price has been drifting lower, not rising in concern. Having fallen just $4 short of an all-time high in early May, it has meandered down from about $2,060 per ounce to about $1,960 per ounce as we write. This $100 dollar slide would seem an odd thing to do if the US were really about to default.
And stocks would hardly be comfortable with a default if that were really about to be the case but their action has been mostly sideways with contracting volatility.
Thus, it would seem the markets are sanguine about how the debt ceiling talks will end up. The markets apparently feel that once again we will see some kind of resolution before it is too late or we will have selected shut down of some government agencies as we have seen before. Closing the National Parks or Passport control is surely inconvenient and damaging to communities that need tourism, but such closures will not wreck the country.
The markets have had to go through this process several times before, and depending on the severity, and how “default” is handled, will dictate the extent of losses and the time necessary to come back from those losses. The last big debt ceiling crisis was in the summer of 2011. It created several weeks of volatile action in the markets, including a decline in stocks of about 21%. Afterwards, markets continued their advance which lasted for several more years. However, the US government suffered its first bond rating downgrade and lost its AAA rating with Standard&Poors with a “negative outlook” going forward.
There was another disturbance in 2013 that was milder.
There are both good and bad in the market’s reactions to these present events. The good news seems to be that markets just don’t believe that our political leadership is that stupid and that most of this is political brinksmanship designed to extract concessions from the other side. There are other things to worry about such as the FED interest rate policy, declining economic growth, and earnings reports softening.
The bad news comes on two fronts. Firstly, the markets are quite unprepared if talks truly run off the rails and the US has to default in some form. If you are unprepared, when reality reveals itself it can lead to rapid panic. Secondly, the two arguing parties might feel greater urgency to solve the problems if the markets were putting them under pressure. The current sideways action just will not be sufficient to catch the attention of our camera-seeking political leaders.
History suggests that what damage is done will be temporary, assuming all other market factors are reasonable.
However, a true default could be much worse and more long-lasting. Then again, getting spending constraints would be a positive for the markets and the economy.
The long-term problem is the current huge build-up of deficits is unsustainable. We cannot keep racking up deficits like this. Spending is far outpacing both economic growth and revenues and the trend seems permanent.
Current Republican leadership knows this and also feels this time, as opposed to previous times, the debt ceiling crisis will be blamed on the Democrats. Current polling does show the public largely supports the Republican plans to trim spending. All that is being asked are quite modest cuts in spending and the return of unspent Covid relief money. They are quite willing to sign on to a debt ceiling increase if some modest common sense things are done.
The Democrats for their part are now a radical party and turmoil serves radical political ends. Some of their most progressive members are now suggesting street violence. For most of the last few months, the Biden Administration flatly refused to even talk to the Republicans knowing full well the end date was coming soon. Then they tried trotting out a strange 14th Amendment Theory. The section of that amendment had to do with integrating the previous states of the Confederacy back into the Union and making it clear, the Union would not be responsible for Confederate debts. The position that this applies to the current circumstance is absurd on its face and one only a constitutional ignoramus could make.
Other novel theories suggest money once appropriated by one Congress is binding on the debt management of another Congress. But if acts of one Congress of one party are an unquestionable obligation of another Congress run by another party, nothing would ever change. That is not the way the system of checks and balances works. Democrats remain convinced they can blame the “crisis” on the Republicans but their desperation indicates that Speaker McCarthy has them and the President cornered. They seem to feel there are no problems always spending more than you take in. The bogus nostrums of Modern Monetary Theory seem to have taken up permanent residence in the Democrats’ brains.
Both the market complacency and the view that this is just another period of political brinksmanship do seem to miss the serious nature of what we are dealing with.
We really can’t go on like this as a nation. The debt burden is now way beyond political posturing. Not that far in the future, the laws of economics will apply to the US just as it has to other countries. We are already in the worst inflation we have suffered in 40 years, an indication we are closer to the breaking point than many think. We are having a rolling banking panic and we are not even in recession. If we nose into recession later this year, revenue will fall (it already is) and expenditures will rise, making the deficit widen once again.
Other great empires have been brought to their knees by financial calamity and both citizens and markets, become collateral damage to government financial mismanagement. Who is to say we are so special as to avoid the consequences of spending forever more than we receive in revenue?
No, we need some sober leadership that gets expenditure and revenues back into balance. However, financing this great country with such chaotic procedures is a burden on all of us and very difficult for the markets to figure out.
The great leader that unified Germany Otto von Bismark is credited with this pithy observation: “There is a Providence that protects idiots, drunkards, children, and the United States of America.”
We worry about how much longer that may be true.