Ok, I don’t know how much figurative “stock” you put in Mitch McConnell’s Monday promise that there is “zero chance” of Congress not raising the debt ceiling by late September, but it’s at least plausible to suggest that however vacuous, the Senate Majority Leader’s comment helped buoy risk assets (i.e. literal stocks) on Tuesday.
Taken together with the Politico article that posited some progress on tax reform, investors may have gone into the cash open feeling a little better about the fiscal situation than they did at the end of last week.
Nevertheless, you can’t blame markets for being nervous. And no matter which side of the partisan divide you fall on, it’s impossible to argue that Donald Trump’s erratic behavior hasn’t made the situation even more ambiguous than it already would have been.
Well on Tuesday, Deutsche Bank is out with a lengthy piece on what the implications are for fiscal policy, Fed policy and foreign flows.
Needless to say, all of that matters quite a lot for the dollar, which has been on the back foot for most of this year, a cruel twist of fate considering “long USD” was one of the “no-brainer” trades headed into 2017.
First on fiscal policy, Deutsche notes the following:
In August 2011, the price President Obama paid for the deal with House Republicans was multiple rounds of spending cuts (the Budget Control Act) with automatic sequestration (the fiscal cliff) if a bi-partisan super-committee failed to find a trillion dollars of additional cuts by November 2012. Combined with funding compromises agreed earlier in the year, this sharply reversed post-crisis stimulus. The US fiscal impulse flipped from an expansionary +2% GDP in 2010 to -1.5% in 2011 (chart 2).
By the October 2013 debt ceiling crisis, with lawmakers having failed to agree on a budget from the previous year, automatic spending cuts had already begun to come into effect. But with House Republicans still unwilling to fund the government without a delay to implementing the Affordable Care Act, the federal government went into partial shutdown. The immediate economic cost of the shutdown was calculated at 0.3 percent of GDP by the Bureau of Economic Analysis. But the backlash ultimately pressured Republican lawmakers into a series of temporary resolutions funding the government over the next three years.
Clearly, the implication here is that a conditional debt ceiling deal will echo for years.
“If conditions are attached to a debt ceiling increase, experience has shown these to have long run effects for markets,” Deutsche concludes, adding that “fiscal tightening was repeatedly identified as one of the ‘headwinds’ identified by the Fed for US economic recovery, and one of the reasons for extremely slow monetary policy normalization.”
In other words: an impediment to fiscal policy’s preparedness to take the proverbial baton from monetary policy in the relay race to keep the U.S. economy afloat.
Speaking of the Fed, Deutsche reminds you that “the Congressional deadline to pass the debt ceiling is seven days after the Fed is expected to announce the start of its balance sheet reduction.”
It seems exceedingly unlikely that Yellen would move (where “move” actually means “not move” on going ahead with balance sheet normalization) preemptively barring some kind of absolute meltdown that clearly telegraphed trouble ahead between now and the Fed meeting.
That said, the Fed would be responsible for bailing out the system should a “mistake” end up squeezing money markets. Here’s Deutsche Bank again:
It’s helpful to understand what the consequences of the worst-case scenario would be, however improbable. The Treasury curve is pricing most risk premium for the start of October (Figure 3), although the administration has acknowledged falling tax receipts over the past year mean Treasury could run out of funds sooner.
If we reached the hypothetical point that the US government was not able to honour its obligations, any US default would be seen as soft, with an assumed 100% recovery value and outstanding coupon payments paid once a political compromise was reached. Also, as there is no cross default clause in US treasury bonds, only treasury bills maturing or coupon payments due during the impasse would be affected.
The main impact would be felt in money markets. Treasury bills provide a source of collateral for short-term funding as well as liquid assets for short term investments. Default could impair the functioning of short term funding markets and also hurt investment funds exposed to government securities.
On the former, the experience of 2011 and 2013 suggests that treasury yields and repo rates would rise. For market participants that use repo as a source of funding for other investments (such as REITs), a fall in collateral values could lead to deleveraging and a knock on impact on other asset values. Defaulted treasury securities might also cease to be accepted as collateral at clearing houses. In 2013, for example, the Hong Kong Clearing House increased haircuts on treasury bills ahead of the debt crisis.
Responsibility for ensuring the continued functioning of short term funding markets would fall to the Fed. In the recently released transcripts ahead of the 2011 debt ceiling crisis, the Fed outlined four groups of actions to ensure short-term market functioning. In summary, to prevent an unwanted rise in short-term rates, the Fed stood ready to aggressively ramp up its repo operations to keep short term rates contained and discussed providing liquidity to depository and non-depository institutions affected by a fall in collateral values. If the market was unwilling to hold defaulted securities and yields on short dated bills rose to very high levels, the Fed discussed outright buying of defaulted US debt.
And here’s another interesting dynamic. Think about the effect money market reform had in terms of catalyzing an epochal shift out of prime funds and into government and agency funds last year:
Obviously, that raises questions about what the scope is for outflows now versus previous episodes and what those outflows would mean for bank CP and short-term deposits (as Deutsche reminds you, money pulled from government money market funds has to go somewhere).
Now think about all of that and ask yourself: what do you imagine might happen should that unfold against a backdrop where the Fed is suddenly letting its balance sheet roll off?
For one thing, if they were forced to buy T-bills, it would create an exceedingly absurd scenario wherein the Fed would be letting long-term assets roll off while simultaneously buying up short-dated paper. God only knows what the knock-on effects of that might be against a backdrop where everyone is already freaking out.
Yeah. Starting to get the picture?
Finally, Deutsche notes there’s a distinct possibility of reduced foreign appetite for USD assets. Here’s some quick color and two visuals on that:
There is some evidence that foreign investors responded to rising risk premium at the time by reducing allocations to US assets. In both 1Q-2Q 2011 and 3Q-4Q 2013, reserve managers’ dollar allocations fell by around 1%, according to COFER data corrected for FX valuation effects. As can be seen in chart six, this was still relatively small compared to other shifts in dollar allocations over the post-crisis period. A cross-check with changes in foreign holdings of US treasuries from TIC data suggests no clear impact for longer dated securities. But there were notable outflows in short dated treasury securities one month before the 2011 and 2013 debt ceiling deadline (chart 7). This suggests that most of the withdrawals took place in short dated treasury securities, reflecting foreign investors’ unwillingness to be exposed to securities that could be in default, but this did not translate into broader aversion to holding USD assets.
Chances are this is just one big thought experiment, as the likelihood of a worst case scenario is almost de minimis.
But then again, one could have said the same thing about Donald Trump’s election, and look how that turned out.