Wall Street Shows Calamity Fatigue as Potential U.S. Debt Default Looms
By the decorous standards of the office of the secretary of the Treasury, Jacob Lew was lighting his hair on fire to get the nation’s attention. “If we have insufficient cash on hand, it would be impossible for the United States of America to meet all of its obligations for the first time in our history,” Lew wrote in a Sept. 25 letter to Speaker of the House John Boehner (R-Ohio) about the possibility the country would default on its debt in just three weeks. “The results could be catastrophic,” he added. The previous day, at a conference in New York, Lew had warned investors that they were acting entirely too calmly amid a crisis.
How did the markets respond? With yet more calm. Stocks in the Standard & Poor’s 500-stock index lost just 0.2 percent on Sept. 25, and the value of U.S. government debt—the asset class on the verge of default, as Lew was reminding the public—actually rose.
If the government runs out of money to pay its bills, which Lew told Boehner could happen as soon as Oct. 17, the effects on the American economy and the global financial markets are inconceivable. It’s never happened, and the belief that U.S. bonds are risk-free is a fundamental assumption that helps set the price of other assets around the world. Adding to the stakes, in a separate congressional impasse, the government halted nonessential operations on Oct. 1, furloughing 800,000 federal workers and shutting down services such as national parks, further hampering a struggling economy.
This is the fourth time in two years that Wall Street has watched a crisis of Washington’s own making unfold, and the reaction of the VIX volatility index, sometimes called the fear index, showed that investors are mostly brushing it off. Although it crept higher after Lew’s warnings on the eve of the government shutdown, the VIX didn’t even crack the top 50 readings of the previous year.
Not all investors were sanguine. The price of insuring against a default in U.S. debt for one year suddenly spiked. But a blasé attitude prevailed: The value of gold fell as the shutdown began on Oct. 1, and the threat of default rose, the opposite of what usually happens in tumultuous times.
“People are losing their sense of fear,” says Bob Johnson, the director of economic analysis at Morningstar. “We have a little bit of a Chicken Little situation, where we’ve screamed so many times the sky is falling that nobody believes it this time—and I think this time the situation really is just a little bit worse.”
Since May 17, when the national debt hit its $16.7 trillion limit, the Treasury has used accounting tricks to make its payments. If its cash reserve runs out on any day after Oct. 17, the date Lew cited in his letter to Boehner, the government would be unable to issue checks to recipients of Social Security and food stamps or make interest payments to creditors around the world. The nation’s borrowing costs would likely rise—by how much and for how long no one knows, since the situation is unprecedented. President Obama has refused to negotiate with congressional Republicans on the issue. “We are not some banana republic,” he told supporters in Missouri on Sept. 20. “This is not a deadbeat nation. We don’t run out on our tab. We are the world’s bedrock investment. The entire world looks to us to make sure the world economy is stable.”
There are a host of reasons for traders’ relative equanimity. First, says Tom Porcelli, chief U.S. economist for RBC Capital Markets, they have a case of calamity fatigue from past episodes of Beltway brinkmanship. “The markets are now trained to think that they are going to get it done, that D.C. will get it done,” he says. “The rhetoric this time is no different. It’s no sharper, it’s no duller, it’s exactly what we’ve experienced over the last few years.”
Second, the global investing landscape is regarded as safer than the last time the U.S. faced default, in the summer of 2011. Since then the European Union has stabilized somewhat, Japan is on a better footing under a new prime minister, and the American economy is two years further into a recovery. The Federal Reserve announced on Sept. 18 that it will continue its stimulus program of buying $85 billion of bonds each month, surprising investors who had expected purchases to wind down. The support has helped prop up bond prices and caused the stock market to rally.
Perhaps most persuasively, there’s an historic case for remaining bullish in the face of manufactured congressional crisis. Investors who dumped stocks the last time the news out of Washington was this grave, as the so-called fiscal cliff loomed at the end of 2012, missed out on a 7 percent gain in the first month of 2013. Investors who got out of Treasuries when Standard & Poor’s downgraded America’s credit rating in August 2011, after the last debt-ceiling stare-down, saw government bonds rally without them.
The current calm in the markets may even be emboldening politicians to inch closer to cataclysm. “The fact that the markets believe people are going to behave responsibly may provide the right incentives to behave irresponsibly,” says Bruce Kasman, JPMorgan Chase’s chief economist. “And I think there is danger here, unfortunately, in the sense that the market is not pricing a serious risk” of default.
Some economists downplay the severity of a default, at least as it would be felt by bondholders. “You have to bear in mind, when we’re talking about a default of the U.S. government, no one is anticipating a wide-scale, unlimited default of government debt,” says Drew Matus, a senior economist at UBS. “What we’re really talking about is you have to wait an extra day for your money.”
Even though seniors and the poor would immediately feel the pain of the Treasury running dry, it might take a stock market plunge to get Congress’s attention. Matus notes that Congress rejected the Troubled Asset Relief Program—the bank bailout that was unpopular but helped end the 2008 financial crisis—the first time it came up for a vote. Investors reacted by driving the Dow Jones industrial average down almost 800 points. Lawmakers passed the legislation a few days later.
“The feeling is, yeah, this thing may go down to the wire, but at the end of the day, the debt ceiling will be lifted,” says Michael Gregory, a senior economist at BMO Capital Markets. Yet he does expect to see more volatility in the markets before the issue is resolved. The August 2011 battle may have ended in higher stock prices, but it sapped public confidence in the economy and hurt hiring and capital spending. “We’re at the cusp of seeing that pick up a bit,” says Gregory. “The calm we’re seeing now, even if they do lift the debt ceiling, will not remain. We will pay a price.”