Once Assumed Debt Ceiling Crisis Resolve Is No Gimme This Time Around
Could the relatively placid markets begin roiling again in September? That’s the view of Morgan Stanley (NYSE:MS), who again warned clients not to neglect the upcoming U.S. debt ceiling crisis at their peril.
In what Morgan Stanley characterizes as a “three-headed policy monster” in Washington, debt ceiling negotiations are also intertwined with budget and tax reform talks. None of those negotiations will come easy in today’s polarized environment, but averting a debt ceiling crisis is the top priority. And there’s not much time left.
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Treasury Secretary Steve Mnuchin has until the end of September before “he’ll run out of authority,” meaning Congress will have mere days to reach a compromise when it returns from summer recess. (Source: “Are Markets Sleepwalking Into A Debt Ceiling Crisis: Mnuchin Issues Another Warning,” Zero Hedge, August 21, 2017.)
While some investors are comforted that the Fed can prioritize debt payments to avoid default, Morgan Stanley analyst Andrew Sheets is skeptical. He notes a trifecta of reasons for his skepticism.
- A reduction of worry towards a pressing issue (a.k.a. “kicking the can down the road” in political parlance)
- Payment prioritization would still involve delays in Medicaid and Social Security payments. This situation cannot last long.
- The mechanization of “priority payments” has never been tested in real-world conditions.
We at Lombardi Letter echo similar concerns. How many times have the political elite reassured the public that all would go smoothly, only to have the opposite occur? There’s also the assumption that foreign creditors wouldn’t be spooked about the extreme political stalemate on Capitol Hill. This undermines a historical pillar of support for the U.S. dollar—political stability. If the dollar tanks, so too, could the U.S. stock market.
A debt ceiling crisis could easily usher in a sovereign credit downgrade, which would hammer the bond market. Remember, a strong credit rating is a key driver of foreign and institutional demand for U.S. Treasury securities. When it degrades, so does investment demand for “risk-free” government securities. This would come at a time when the Fed is actively reducing its balance sheet. Nothing like a debt ceiling impasse to plant the seed of doubt into foreign buyers.
We’ve already seen the damage a credit downgrade could do in 2011, when the credit rating agency (CRA) Standard & Poor’s Financial Services LLC (S&P) downgraded American debt to AA+ due to soaring debt concerns. The difference? That event occurred four days after the 112th United States Congress voted to raise the debt ceiling.
Major Credit Agency Ratings and Outlooks: United States Since 2000
| Agency | Rating | Outlook | Date |
| DBRS | AAA | stable | Apr. 22 2014 |
| Fitch | AAA | stable | Mar. 21, 2014 |
| Fitch | AAA | negative watch | Oct. 15, 2013 |
| Moody’s | Aaa | stable | Jul. 18, 2013 |
| S&P | AA+ | stable | Jun. 10, 2013 |
| Fitch | AAA | negative | Nov. 28, 2011 |
| S&P | AA+ | negative | Aug. 5, 2011 |
| Moody’s | Aaa | negative | Aug. 2, 2011 |
| S&P | AAA | negative watch | Jul. 14, 2011 |
| Moody’s | Aaa | negative watch | Jul. 13, 2011 |
| S&P | AAA | negative | Apr. 18, 2011 |
| Fitch | AAA | stable | Sep. 21, 2000 |
(Source: “United States | Credit Rating,” Trading Economics, last accessed August 24, 2017.)
Nonetheless, the market reaction was fierce. In the first day of trading after the downgrade, the Dow Jones Industrial Average (DJIA) lost 635 points (a 5.6% drop) and the S&P 500 lost 6.7%. Although stocks recovered the majority of losses the next day after dovish Fed jawboning, the losses may not stop this time around. We’re coming from a different place now. An early business cycle and reasonable valuations have been replaced by excessive valuations at a business cycle past its peak.
Only now, investors seem to be waking up to the impending danger.
In the near term, Goldman Sachs Group Inc (NYSE:GS) sees a 50% chance of a brief government shutdown. Although the debt ceiling has been raised 78 times in the last 57 years, we’re in the era of Donald Trump. It’s unclear whether this issue will be used as a battering ram for opponents to reinforce the “impeachment” narrative. With zero legislative wins in Congress to date, stalemate has ruled the day. Why are we to expect that tough-slog debt ceiling negotiations will pass through without a hitch?
In the end, the 2011 credit downgrade concern probably wasn’t about hard numbers. It was a referendum of the chaos in Washington, creating lasting political instability. This is damaging to investor confidence, the dollar, and—by extension—the creditworthiness of America. Whether a U.S. debt ceiling crisis occurs in 2017 is anyone’s guess. But, judging by the direction in Washington, it seems more likely than not.
