Investors hit snooze button on U.S. debt alarm: James Saft

October 27, 2015

Oct 27 (Reuters) – With less than a week to go before the
U.S. runs out of money to pay its bills, you’d be forgiven for
thinking that very few investors actually care.

Outside of remote corners of finance, like the market that
offers, arguably pointless, insurance against default, there
have been few sizable moves in prices traceable to the prospect
of the U.S. hitting the debt ceiling, something that absent a
deal will happen Nov. 3.

Short-term Treasury bills have been hit, sending minuscule
yields higher by commensurately small amounts, but even when the
Treasury last week cancel led an auction planned for Tuesday the
result was far from carnage.

Taking a broader look at risk assets, the debt ceiling issue
has coincided with a 7.5 percent rally in the S&P 500
over a month and the highest inflows into high-yield bonds in
eight months last week.

Granted, all of that may have more to do with the
expectation that the Federal Reserve will wait a while more
before raising interest rates.

Still, the very fact that the U.S. is now whistling its way
along as it approaches potential default for the third time in
four years tells us much about the world.

Investors may complain that the political system is broken,
but they fail to see how that is a problem for them. That’s in
large part because of the huge natural appetite for safe assets
– and even a week before running out of cash, the U.S. is as
safe as it gets.

Investors have also drawn a lesson from recent history: that
politics aside, policymakers, often central bankers, will pull
their fat from the fire. That belief, supported by events of the
Great Financial Crisis and the European debt affair, may be
naive but is now a feature.

It has also not escaped investors’ notice that although
markets have been hit with varying intensity in both previous
debt ceiling episodes, in 2011 and 2013, in both instances a
deal was done and chaos averted.

And so it likely will be this time.

Reports on Monday indicated that a tentative deal may be
close, potentially setting up a Wednesday vote. The Treasury has
warned the government will default if the ceiling isn’t raised
by Nov. 3, at which point the government may have as little as
$30 billion on hand, less than upcoming Social Security and debt
interest payments.

EQUITIES DOWN, TREASURIES UP?

Based on past episodes, should a deal not materialize as we
approach the date, movements in financial markets will get
larger, though they are highly unlikely to be consistent with
anything other than temporarily missing payments.

Equities surely will sell off; after all the only balm in
the story for stocks is that the Fed surely won’t raise rates
while negotiations are ongoing, a position they likely have
reached anyway for other reasons.

Equities did fall sharply during the 2011 debt ceiling
crisis, and were especially hit hard when Standard & Poor’s
downgraded the U.S.’s credit rating. The stock market fell too
in 2013, but by less, perhaps taking heart from 2011’s ultimate
resolution.

“The other side of this is that, perhaps
counter-intuitively, long-dated Treasury yields could fall,”
Andrew Hunter of Capital Economics in London wrote in a note to
clients.

“Of course, investors might worry about a delay or temporary
default on coupon payments. But such fears would probably be
outweighed by an increase in safe-haven demand and growing
expectations that the Fed would remain on hold for longer.”

The salient fact isn’t that U.S. debt becomes more risky
during a debt crisis, it is that it is still the safest liquid
asset out there. Investors react to the U.S. becoming less safe
by lightening up on risk, which, as the U.S. remains safer than
stocks or foreign bonds, argues for selling stocks while buying
up Treasuries. To be sure, short-term rates spike in these
episodes, upsetting money markets.

It is probably true that the drip, drip, drip of U.S.
political dysfunction is having a cumulative effect on its store
of credit among investors. Eventually, the price of this may
rise, but certainly not at a time of stagnant growth when
central banks around the world are preparing to ease further
rather than hike.

Those, like Treasury Secretary Jack Lew, who bemoan the
risks that this process runs are quite right, but thus far the
actual butcher’s bill has been low enough to be safely ignored.

Whether due to a long track record of holding it together
politically, or the faith that the “grown-ups” like central
bankers will help cushion any blow, the U.S. has enough credit
to allow it to some day sleepwalk its way into real trouble.
(At the time of publication James Saft did not own any
direct investments in securities mentioned in this article. He
may be an owner indirectly as an investor in a fund. You can
email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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