The Market Calm Before the Debt-Ceiling Storm

President Obama all but asked for a stock market selloff to spur lawmakers into action in an interview that aired Thursday on CNBC. Asked by the New York Times’s John Harwood if Wall Street’s indifference to the government shutdown and looming debt-ceiling crisis was the right reaction, the president replied with a terse, “No.”

The markets aren’t listening. As of Friday afternoon, stocks were trading modestly higher. Even after the Dow dropped 137 points Thursday, it still looks primed to finish the week less than 100 points below where it opened Monday, just before the government shutdown started. “We’re all a little surprised that the markets haven’t sent more of a signal,” says David Ader, head of rates strategy at CRT Capital Group.

During similar moments of congressional gridlock, market freakouts have actually goosed lawmakers into action. On the day Congress initially failed to pass the TARP bailout plan in September 2008, the Dow dropped 770 points, more than 7 percent, and dynamics started to shift. Four days later, of course, the legislation passed and markets rallied. When lawmakers fought over how to avert the fiscal cliff last December, the Dow lost about 400 points before a deal was finally reached.

Investors may be looking at what happened during the last debt-ceiling game of chicken that Congress played in the summer of 2011. In the days leading up to the Aug. 2 deadline, the stock market slowly dribbled down for about a week before lawmakers reached an eventual agreement. That dribble turned into a 600-point firesale after S&P downgraded the U.S. credit rating. The hysteria that followed lasted well into the fall.

Considering the flight to safety that resulted from the downgrade, as global investors fled stocks and poured money into U.S. Treasuries, markets may not be terribly worried about the consequences of another protracted debt-ceiling debate so long as a deal is reached before the U.S. defaults. But things have changed in the past two years. In 2011, fears over Europe’s sovereign debt crisis were at their peak, and Japan was still reeling from its tsunami and nuclear disaster. Relative to the rest of the world, the U.S. looked pretty strong back then.

While that’s still true, investors have more options this time around, says John Fath, a principal of BTG Pactual in New York, which has $9 billion in assets under management. The idea that if the U.S. gets close to default again, the world will simply flee back into U.S. sovereign debt is “a very dangerous way to think,” says Fath. “The availability of quality assets is bigger now. Money will not necessarily flow back into Treasuries like it did last time.”

Tremors of a coming market reaction are starting to shape up in the bond market. Yields on U.S. debt that matures on Oct. 17—the same day the Treasury Department runs out of cash—have gone vertical in the past week (see above graph). So have the prices of credit-default swaps on U.S. debt, having more than doubled since Sept. 19.

“Those are the early seeds of trouble being planted,” says Ader. He also worries that the hollowing out of trading desks at the big broker-dealer banks over the past two years could potentially accelerate whatever selloff occurs, since there won’t be as many traders willing to buy what investors are selling. “We have the potential risk that if the market decides to start selling, there won’t be enough broker-dealers to stand on the other side of those trades,” Ader explains. “The real brazen traders have all moved to hedge funds, so who’s gonna be there to buy? You have no depth in the dealer community at the moment, certainly not enough to handle a selloff.”

Sadly, that kind of dislocation might be the only thing that can actually motivate lawmakers to reach a deal.

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