Postponing Washington's urgency

The Washington shutdown, the greatest show about nothing since Seinfeld, is entering its third week – and Wall Street is finally showing signs of wear ahead of the October 17 debt ceiling deadline. There’s nothing like a deadline to focus the mind.

Overnight, short-term Treasury yields began rising with greater speed, while demand for two short-term US debt sales was weak, a signal investors were starting to shun US debt.

Stocks, which have been remarkably resilient since the shutdown, slumped 1 per cent and the volatility index jumped 16 per cent. Even more recently, the first significant response from a ratings agency enhanced the tension, with Fitch placing the US on ‘ratings watch negative’.

While they are indications of anxiety, they’re not extreme moves because market players still expect an eleventh hour arrangement – even if a deal remains as far away now as it did a few days ago.

As it stands, a Senate plan has been dismissed by House Republicans, who are pursuing an alternative arrangement that could see the ceiling raised until December 15. That plan, currently at risk of collapse, will likely not clear the Senate due to its focus on restricting Obamacare. Urgency remains 24 hours away.

Even then, there is a risk of inaction as October 17 is just a soft deadline. Confusion reigns about the Treasury’s ability to prioritise debt payments but, according to Moody’s, a default is not technically possible until October 31, when $5.9 billion in interest is to be paid.

“Moreover, given that the amount that needs to be paid is relatively small, a default is also extremely unlikely,” Steven Hess, Moody’s lead US sovereign credit analyst, explained.

The Fitch move, meanwhile, was the first hint of major ratings agency concern, a contrast to the last time the debt ceiling was a big issue in 2011. Back then, Standard & Poor’s caused a stir with its decision to cut the country’s credit rating from AAA to AA . Now things are not completely the same, according to the chair of the company’s sovereign ratings committee, John Chambers.

“I think it’s similar to 2011,” he told Bloomberg TV ahead of the latest trading session on Wall Street. “(But) the main difference is the fiscal deficit position now is much, much better.”

What is intriguing, and perhaps worrying, is that Chambers was working on the assumption a solution will be achieved by Thursday. Until Fitch – which retains a AAA rating for the US – made the negative watch announcement at 0745 AEDT, the threat to the country’s credit rating was not present.

“If you think there’s going to be an eleventh hour deal, you have to wait until the eleventh hour,” Chambers explained. “That’s our working assumption: we think something will get done.”

Should a default occur, however, it would be more painful to the global economy than the Lehman collapse, according to Chambers.

That assumption of a likely deal has likely had the effect of slowing progress in Washington, as Robert Gottliebsen noted this morning. If the markets had taken the risk of default seriously, rather than assuming that ‘even the Tea Party wouldn’t be stupid enough’ to trigger one, then we should have seen falls or 3 per cent, 4 per cent, or even 5 per cent.

Two or three days of such Wall Street weakness would quickly catch Washington’s attention. But alas, we roll on, Wall Street confident one side will blink and neither willing to do so.

In fact, since the government shutdown the S&P 500 is actually up 0.3 per cent – remarkably, given the uncertainty and the lack of data. The volatility index, a closely watched indicator of investor concern, has also shown little action. As the chart below highlights, recent highs in the ‘fear gauge’ have been well below those seen in 2010, 2011 and 2012. Compared to 2008 and 2009, they barely even register.

Source: Yahoo Finance

The US Treasury hopes the Fitch move might finally elicit a more serious Washington response, saying it “reflects urgency” needed for swift action. Already the news has sparked a tumble on Dow futures markets, which should ensure Asian markets have a day of significant falls.

Through it all, however, QE-addicted markets have had one silver lining to cling onto: the prospect the Federal Reserve’s taper timeline will be pushed back.

Even Fed board member and noted hawk Richard Fisher, the president of Federal Reserve Bank of Dallas, hinted overnight that the option of an October taper is now dead.

“My personal opinion is it’s not in play,” he told Reuters. “This is just too tender a moment.”

Meanwhile, most market participants are now calling February the most likely month for the taper to start. With this as the background, prepare for a significant relief rally should a deal get done in the next few days.

It’s best not to think about the alternative.