A $24 Billion Standoff — October 17, 2013

Wednesday night, Congress approved and the president signed a bill that reopens the federal government and extends the U.S. borrowing authority. As we noted in yesterday’s update (see below), government operations have been funded through January 15 and the debt ceiling has been extended through February 7.

A committee of Senators and Representatives will convene immediately and is required to present a long-term budget proposal by December 13. The final piece of the agreement requires that individuals or families seeking subsidized health insurance coverage through Obamacare will need to verify their incomes before getting a subsidy.

The government shutdown cost the U.S. economy $24 billion, according to an estimate from Standard & Poor’s, a loss of 0.6% of annualized fourth-quarter GDP growth. And the ratings agency suggests that the loss could get worse:

If people are afraid that the government policy brinkmanship will resurface again, and with it the risk of another shutdown or worse, they’ll remain afraid to open up their checkbooks. That points to another Humbug holiday season.

In September, S&P estimated U.S. fourth-quarter GDP growth of 3% because the firm believed “politicians would have learned from 2011 and taken steps” to avoid another both a shutdown and a possible default. Since politicians are evidently ineducable, S&P has cut its GDP fourth-quarter growth forecast to 2%.

Senate Deal Going to a Vote — October 16, 2013

The Republican and Democratic leaders of the U.S. Senate have reached an agreement to end the federal government shutdown and to extend the nation’s debt limit. The news has lit a fire under equities shortly after noon today.

Under the terms of the deal federal government operations will be funded through January 15th and the Treasury’s authority to borrow will be extended through February 7th.

Texas Senator Ted Cruz has said he will not block a vote in the Senate over the deal’s failure to provide a delay or halt to the implementation of Obamacare. A Senate vote is expected take place before the end of today.

A vote in the House is also expected, but there has been no indication from House Republican leaders on when a House vote would take place or whether House Republicans would support the Senate measure.

President Obama, who must sign the bill if it passes both houses of Congress, has not commented on the agreement.

The deal does make a minor concession to opponents of Obamacare: individuals or families seeking subsidized health insurance coverage will need to verify their incomes before getting a subsidy.

The S&P 500 index is up 1.16% and the DJIA is up 1.17% shortly after 1:00 p.m. ET on Wednesday. The Nasdaq Composite is up 1.08%.

Equities Blind to Default — October 16, 2013

Hope springs eternal, and nowhere more eternally than the U.S. equity markets. Given Washington’s failure so far to reach a solution on the impending federal debt limit, one might think that equities prices would be collapsing. Think again.

Here is how the three major stock indexes have reacted:

September 30 close

• Nasdaq: 3,774.34
• S&P 500: 1,681.55
• DJIA: 15,129.57

October 15 close

• Nasdaq: 3,794.01, up 0.52%
• S&P 500: 1,698.06, up 0.98%
• DJIA: 15,168.01, up 0.25%

Index futures are up again Wednesday morning. What are these guys smoking?

It could be that the expected effects of a U.S. default may be less catastrophic than most predictions. But that is not a given, and the uncertainty would lead an observer to think that markets that traditionally hate uncertainty would respond with a sell-off, not a buying spree.

The most likely explanation is that traders expect any default to be short-lived. If that is the case, they will buy the dip, or at least the slight recent dip from 12-month highs. Any solution to the government shutdown and potential default also likely will be temporary, which means we get to go through all this again in a few months. Think of tomorrow’s end to U.S. borrowing as a practice run for the next time the debt limit is reached. Call it the new abnormal.

Social Security and the Default — October 15, 2013

U.S. equities futures are trading a bit higher Tuesday morning following several optimistic comments from politicians on both sides of the aisle late Monday. A scheduled afternoon meeting between President Obama and congressional leaders was cancelled as the legislators said they were making progress and wanted to continue working to hammer out a deal.

We wrote yesterday about the influence of the bond market and noted that China is the largest holder of U.S. debt. But the largest holder by far, with about twice the amount of U.S. paper, is the Social Security trust fund. The federal government owes the Social Security trust about $2.6 trillion.

The money the government owes to Social Security is not part of the public debt covered by the 14th Amendment to the U.S. Constitution. It is at best an obligation that can be prioritized for payment. The debt to the Social Security trust is pretty far down the list of which creditors get paid first.

But that does not mean that payments to retirees and other beneficiaries will stop on October 18, or any time. Receipts from taxpayers produce a steady stream of income to both Social Security and Medicare. The combination of the tax income and contributions from the trust could continue to pay benefits for quite some time, even in the event of a default.

Of course that state of affairs cannot last forever. According to the latest report, the trust fund begins to be depleted in 2021, and by 2033 it will be unable to pay scheduled benefits in full on a timely basis.

It’s All About the Bond Market — October 14, 2013

In remarks last Thursday, President Obama got to the heart of the matter: “Ultimately, what matters is: What do the people who are buying Treasury bills think?”

It looks like bond buyers think they had better get paid more. The yield on four-week Treasury bills rose from around 0.12% to 0.36% last week. The benchmark 10-year Treasury note peaked at around 2.72% before closing the week at 2.69%.

Also last week, the yield spread between the interbank overnight lending rate (LIBOR) and the four-week Treasury bill went negative for the first time since 2001, according Bloomberg News. That means banks could borrow more cheaply than the U.S. government.

The total U.S. debt is around $16.8 trillion. The following chart from National Public Radio shows to whom that debt is owed.

The largest foreign holder of U.S. debt is China, with $1.3 trillion — and the Chinese are not happy. An article from the country’s official news agency, Xinhua, suggests that the current impasse over the U.S. debt limit provides the opportunity for “the introduction of a new international reserve currency that is to be created to replace the dominant U.S. dollar.”

The Middle Kingdom also is making noises about selling more of its debt, although the reality is that doing so is easier said than done. At the first hint that China is dumping a larger than usual amount of its holdings of U.S. securities, front-running bond dealers very likely will begin selling their own holdings.

The effect will resemble the lock-up in the financial markets following the collapse of Lehman Brothers. No one will know what U.S. Treasury securities are worth, and their value as collateral will evaporate. The financial crisis of 2008-2009 will look like a practice run.

Confidence Is the Big Loss — October 11, 2013

As October 1 drew nearer, Americans’ confidence in the nation’s economy started to dip. By the end of last week, after the federal shutdown had been in effect for four days, economic confidence had sunk to a low not seen since the collapse of Lehman Brothers in the fall of 2008. Does that mean that Americans expect the same result, even though the effects of the shutdown are relatively small given the overall size of the U.S. economy?

As Americans go about their daily lives, they are certain to bump into an issue related to the shutdown. National Parks are closed; the Bureau of Alcohol, Tobacco and Firearms is closed and not issuing licenses to craft brewers; the Small Business Administration has curtailed its lending programs; and the Federal Housing Finance Agency has ceased lending for multifamily housing units and may have to stop lending for single-family housing units if the shutdown drags on.

The costs — monetary or emotional — of dealing with these issues cause ordinary people to lose confidence in their government. Political polls indicate that Americans’ opinion of Congress is at an all-time low, and failing to avoid the shutdown is a major reason for the poor ratings.

For many people, that poor opinion translates into more cautious spending, and the longer the shutdown continues the more people worry and the more cautious they become. Heading into the biggest retail spending period of the year while consumers worry about the overall economy is not good for retailers or the economy as a whole.

Based on previous experience with government shutdowns, we can pretty safely say that the impacts of the current shutdown will be short-lived. Far more dangerous are the potential impacts of a default on the federal debt. We will look at some of those over the next few days.

Impacts Hard to Measure — October 10, 2013

U.S. equities staged something of a relief rally Thursday morning on talk that a short-term deal to raise the debt ceiling may be in the making. If a deal is reached on the debt ceiling, then we might also expect to see an end to the federal government shutdown that has idled about half of the 800,000 federal civilian employees.

The next focus on the economic damage caused by the shutdown is likely to be on veterans and military families. The Department of Veterans Affairs (VA) has said that it cannot ensure that $6.25 billion in payments to VA beneficiaries will paid on schedule November 1. The VA has furloughed about 7,800 staff, causing its claims backlog to grow by 2,000 since October 1.

In a particularly wrenching instance, four families that would normally receive a death benefit of $100,000 each for the combat deaths of a family member will now get nothing, not even payment for expenses to bring their loved ones’ bodies home.

In a more general case, mortgage lending will slow down, if not stop, on Federal Housing Authority (FHA) loans. The FHA staff cuts have virtually ended lending for condo purchases, and no new condo projects are being considered during the shutdown. Depending on the length of the shutdown, loans for single-family homes could be affected, and that will have a severe impact on homeowners, sellers and the recovering housing market as a whole.

Assessing the impacts of the shutdown is tricky until it ends because we will be unable to tell until then the actual extent of the harm. The 1995 and 1996 shutdowns lasted a total of 26 days and cost the country about $1.4 billion ($2.1 billion in current dollars), according to a report from the Congressional Research Service.

Defining the Problem — October 9, 2013

Political disagreements aside, the failure of the Congress to adopt a federal budget for fiscal year 2014, or to pass a continuing resolution to keep the government operating until Congress could pass a budget, has a real economic impact on real people who depend on federal spending. Market research firm IHS Inc. (NYSE: IHS) has estimated that the shutdown is leaching an average of $160 million a day from the U.S.’s $15.7 trillion economy.

The decision to pay federal employees retroactively for time missed because of the shutdown has dulled the impact somewhat for those employees, but the knock-on effects remain for businesses that indirectly benefit from federal spending. The tourism industry that supports towns near the nation’s closed national parks are one example. Mortgage lending also feels the effects. Federal lending to small businesses has dried up, and hiring plans that depended on getting the loans have been put on hold if not.

Moody’s Investor Services offers three reasons why the shutdown and impending default on the U.S. debt have so far failed to gin up a lot of concern in the financial markets. First, the ratings agency said, the country has been through this before and, despite all the rhetoric, managed to avoid disaster. Second, the financial world will not end on October 18 if the United States fails to make its interest payments on the 17th. Third, even if there is a default, it likely would be a short-lived “technical” default that could be cured quickly.

Perhaps Moody’s is right. At the rate we’re going, they had better be.

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