Heads in sand over game of chicken

The international equity markets, which are traditionally traded as much on sentiment as on fundamental value, seem to have been injected with a dose of anxiety-relieving Prozac or indulged in a bit of therapy.

The international equity markets, which are traditionally traded as much on sentiment as on fundamental value, seem to have been injected with a dose of anxiety-relieving Prozac or indulged in a bit of therapy.

Regardless of the relentless Armageddon scenarios around the potential failure of US politicians to reach an agreement on raising the nation's debt ceiling, investors have emerged as optimists/realists.

For weeks now they have been taking a punt that, despite both sides of US politics appearing intractable, a resolution would be reached. As the clock ticks down to the deadline Thursday (US time) this bet looks increasingly likely to pay off.

Meetings between Democrats and Republicans set for Monday have been postponed as progress towards a resolution is picking up some pace. Senate leaders said they were close to a deal to raise the debt ceiling and reopen the government.

According to US media, congressional leaders are discussing a deal to fund the government until January 15 and raise the debt ceiling until about mid-February.

The general lack of hysteria in equity and debt markets around the world is a marked change from a few years back when the European financial crisis was in full flight. Equity and debt markets were then buffeted around for months as various financial cliffs loomed but no country was ever allowed to fall.

While there were (and still are) serious financial concerns about some European economies, the various deadlines for bailouts and debt repayments were also about sovereign political brinkmanship.

Plenty of investors lost of lot of money in the European panic, but they appear to have learnt a lesson.

The markets also lived through the resolution of the 2012 US fiscal crisis, which made it over the line, albeit with only three hours to spare.

The US government is likely to butt up against the latest deadline in the same way as the world's biggest game of chicken gets played out.

The bottom line is that the consequences of the US hitting its $US16.7 trillion borrowing cap on Thursday would be too great for either party to allow it to happen.

The fact that it has been allowed to get this close injects an unnecessary layer of instability into the international financial system.

Even though the odds are in favour of a deal being done, the ramifications of failure are so enormous that playing the game of chicken is appalling and unacceptable and those who bankroll US political parties that take extreme positions may need to rethink their support.

If the debt ceiling is not raised, the US government will not be allowed legally to add to the national debt and within days will be short of revenue to meet its outgoings.

The Congressional Budget Office estimates Washington would start missing payments between October 22 and the end of the month. It could miss a $US12 billion payment because of its Social Security pension program on October 23.

Around this time, the economy would start sinking like a stone and spending would need to be slashed as people owed money by the government wouldn't be paid.

Economists predict that even if the debt ceiling was hit temporarily it could cause a recession in an economy growing only modestly.

Goldman Sachs estimates the spending cuts could take the equivalent of about 4 per cent of national output out of the economy.

Experts predict that the contagion effects on the global economy would really kick in after this as the value of US debt, which provides the security for trillions of dollars of loans throughout the international financial system, is called into question. It is a potential calamity whose ripple effects are almost too large to contemplate.

The dire warnings have been routinely issued by the heads of the world's largest investment banks over the past couple of weeks in part as a threat to US legislators to sort out a compromise - or else.

"It would ripple through the global economy in a way that you couldn't possibly understand," JPMorgan chief executive Jamie Dimon told a finance conference at the weekend.

There are reports that in recent days, major money market mutual funds - including Fidelity, JPMorgan and Pimco - have started shunning US debt due between October 17 and the middle of November.

"It would be chaos," said US Treasury Secretary Jack Lew.

Ironically this is precisely why the markets, including those in Australia, have taken the view that the US government couldn't allow it to happen.

The minutes from the Reserve Bank, released on Tuesday, contained no sense of impending doom. The RBA hedged its bets on future interest rate movements but gave no real sense another cut was in store unless some deterioration was in the mix.

Assuming the US does find some resolution on the debt-ceiling crisis, interest rates in Australia are likely to remain on hold for the remainder of the year as our economy continues its incrementally positive response to previous rate cuts and tentative signs of improved consumer and business confidence, and an improvement in property prices.

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