The Circus Is Back In Town
From the September HRA Journal: Issue 203
Well, the taper talk is still on but it's playing second fiddle to Washington's annual game of chicken. The next month will be all about US government shutdown and a game of "will they or won't they?" on the debt ceiling. I'm pretty convinced a sizeable percentage of the US Congress might be clinically insane but I can't believe they will actually go over the debt cliff. It's clear from the relatively calm markets that few other traders believe it either.
With a political climate as divisive as the one in Washington we really can't rule anything out. Any comments in the Update section should be read on the assumption they all end with the phrase "assuming the idiots in Washington don't blow up the galaxy in the meantime…"
The Fed surprised me by choosing not to taper at its September meeting. That decision went over well with investors. Just about every sector staged a huge rally as soon as the news was out and the gold sector was one of the most ebullient.
The happiness didn't last long. As I noted in the last issue of the Journal, choosing not to taper bond purchases at the September meeting hasn't taken the issue off the table. Traders are still going to try and second guess the timing. That means the "Good News Bears" will continue to generate selling when the US reports good economic readings and buying when it announces bad ones.
In addition to the taper decision Fed watchers want to see who is nominated to be the next Fed chair. Larry Summers made what I thought was the right decision by dropping out of the race. When Democratic caucus members are telling you they will vote against your nomination it's a good idea to drop it.
The market expects Janet Yellen to be a shoe in. She probably is unless Obama nominates someone else out of spite. I doubt he's pleased to have his favored candidate Summers dissed by his own party. Though Bernanke is retiring from the Fed in January I doubt his replacement is on top of Obama's agenda.
Obama's got bigger things to worry about right now. This year's budget and debt ceiling grudge match are on and that will dominate the markets until they are settled.
As this issue was finished the US Congress dominated by Republicans and the US Senate dominated by Democrats have been trading "continuing resolutions". This document basically extends the current budget, which lapses at midnight on September 30th, for a specified period of time. This gives the two sides time-in theory anyway-to come up with a compromise budget that will carry through the next fiscal year.
Unfortunately, compromise is in short supply in Washington right now. The Republicans send every bill to the Senate with language attached to defund the Affordable Care Act (aka "Obamacare") and the Senate strips out that language and sends it back.
I don't know where things go from here but the US government is now under partial shutdown of unknown duration.
Senior Republicans were planning to save the real fight for the debt ceiling debate which is only a couple of weeks away. The Tea Party caucus wouldn't go along with that so we get to watch two fights now, one over the budget and one over the debt ceiling.
I'm not a Washington political strategist, or American for that matter, but I know what I would be telling Obama if I was his advisor. It's obvious to everyone that the next few weeks are going to make or break the second term of his presidency. The only way he gets taken seriously for the next three and a half years is to "win" this fight.
In most people's opinion "winning" means Republicans back down or at least agree to a compromise that isn't merely cosmetic. If Obama caves as he was judged to have done in 2011 he might as well call the moving van. He'll be president in name only and have virtually no chance of passing serious legislation after that. It's not really about rights and wrongs, its about perception. If the consensus is that Obama can be pushed around he will be for the rest of his term. Welcome to politics.
Bringing things down to the level of personalities and civil war within the GOP seems petty but, really, that is what we're talking about here. This is a good old fashioned game of chicken and only the players themselves know when they will blink.
To complicate matters there are two games of chicken going on simultaneously. One between the Democrats and Republicans but the more important one within the Republican party itself. The Tea Party wing of the GOP isn't big enough to pass anything on its own but its big enough to make it almost impossible for the GOP to pass bills unless at least some of them go along.
There is a lot of theatre on both sides of the issue. Its likely leaders of both parties will go along with some sort of compromise deal in the end but extremists may try and scuttle any deal for as long as possible.
What does this mean for the markets? Traders have been impressively calm until now. There has been plenty of editorial histrionics in the financial press but, really, the market reaction has been minor so far. The charts on top of the next page display the S&P index and gold for the past three years. The drop in the S&P and rise in the gold price during Q3 2011 are both pretty impressive. There were several things going on but a big driver for those swings was that year's installment of the budget/debt ceiling wrangle.
By contrast, current moves in both gold and equities on the right side of the charts are barely noticeable. No one's panicking yet, really.
In 2011, there was a dive in late-July/early August as the government shutdown loomed. There was a bounce when a temporary deal was announced to avert the budget impasse. Things fell again as that year's debt ceiling negotiations went down to the wire and as a couple of bond ratings agencies stripped the US government Treasuries of their AAA.
As scary as the charts might look to some, events of 2011 created spikes up (in gold) and down (in equities) that dissipated fairly rapidly. It's not surprising that traders looking at these charts now would be wary about piling on the short term trend in either market. The simple truth is that the world didn't come to an end two years ago. For all the hand wringing about the rating on US debt being cut markets really didn't care. Treasury yields dropped after the ratings cuts.
That history has kept traders from over reacting so far but that could change. Remember, there were eleventh hour deals that averted a government shut down or any sort of "debt default" in 2011. As this is written a partial government shutdown is certain. The main effects will be felt by government employees that are not part of mandated spending programs, maybe 800,000 in all.
That would be tragic but it won't kill off the US economy. Estimates are for a 1.4% drop in Q4 growth if a shutdown lasted for 3-4 weeks. Not great obviously but survivable. The impact almost purely based on lost income and lost spending by those 800,000 workers.
All of this is based on a partial shutdown starting October 1. If the Republicans get their way and we can believe their current comments an even bigger fight over the debt ceiling will continue through October.
US Treasury officials expect to run out of room to avoid the debt ceiling in mid to late October. If the US can't issue new debt the number of people going unpaid would explode to cover most of the military, many "essential" positions and millions more dependent on direct government payments like Social Security.
The US has never breached the debt ceiling. Its uncharted territory and that alone could be enough to generate some shockwaves in the market. Let's be clear. The US is not Argentina. Even if the US can't borrow temporarily there is still revenue coming in to cover interest payments, and then some. I personally think there is zero chance of the US actually defaulting on a bond issue even if there is no short term debt ceiling deal.
The real problem if the debt ceiling is hit is that the US government has to dial down spending to match revenues which would be like an immediate trillion dollar plus spending cut. That idea probably has tea partiers delirious but they won't be as happy if it drives the US back into recession. It almost certainly would.
There has been some "risk-off" trade, but nothing like 2011. Two years ago the risk-off trade was very good for the gold market. We are not seeing a repeat. We may see a rally if the impasse continues until we bump up against the debt ceiling. That is the real danger point.
The truth is that even with a government shut down about to start hardly anyone believes politicians will mess with the debt limit. The concept just seems too crazy. Traders are not positioning for an event that seems massively unlikely.
They are probably right; saner heads should prevail and cobble together a compromise before the debt limit is reached. Every day that passes without a deal will lessen trader's sense of calm. If we're still waiting for a compromise in two weeks things could get ugly until a deal is in place.
The $US and US Treasuries may benefit if "default" fears grow. Yes, that is crazy but sometimes the market is. There are few places funds throwing billions of dollars around can hide. The US Treasury market is liquid enough to handle that sort of funds flow. I don't see the big boys giving up on it unless the politicians are actually insane enough to allow a default.
This mess adds another reason for the Fed to keep QE going. If there isn't a quick compromise the danger of employment growth falling off again and consumer spending drying up again are high. There isn't much doubt the political gridlock in Washington was a major factor holding off tapering.
Unless politicians put together a deal that scraps the debt ceiling it must be assumed the circus will swing through town every time that limit is neared. For those of us that trade gold and resource stocks maybe we should encourage gold bugs to stop yelling "gold standard!" and just scream "Bring on the clowns!" instead.
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