Up and Down Wall Street
U.S. Debt-Ceiling Drama: Bad Actors,Tired Script
America lumbers toward another battle over whether to borrow to pay its bills in full and on time. Also, are we experiencing a bear-market rally?
By Randall W. Forsyth
But stocks slid in the aftermath of the S&P move. The Standard & Poor’s 500 plunged 6.7% right after the debt downgrade and ultimately suffered a 19% correction (although concerns about Federal Reserve policy and Europe added to the worries at the time).
“I am not a member of any organized political party. I am a Republican.”
So might have quipped Will Rogers were he alive today (and about 180 degrees turned from his political philosophy). With the GOP thrown into chaos by the sudden withdrawal of Rep. Kevin McCarthy of California from the race for the speaker of the House of Representatives, the winners are the late humorist’s heirs on late-night television—but not the financial markets.
While the fractious House Republicans try to come up with a successor to outgoing Speaker John Boehner, deadlines loom for major fiscal measures. First and most pressing, the Treasury says it will have exhausted all of its borrowing authority by Nov. 5, which yet again raises the specter of the first-ever default by the United States of America. Then, on Dec. 11, the government’s stop-gap spending authority runs out, which could lead to another shutdown of the federal government.
This week, Congress is off for Columbus Day, on which the members won’t be sailing the ocean blue, but probably trawling the sea of green to fill campaign coffers. Boehner has offered to stay until a new speaker is chosen, even past his resignation from the House on Oct. 30. (It turns out that the speaker doesn’t have to be a member, but a nonmember filling the post would appear to be unprecedented.)
The one consensus candidate who could attract the requisite 218 votes for the speaker’s job is Paul Ryan of Wisconsin, the highly respected fiscal expert who chairs the House Ways and Means Committee and was Mitt Romney’s vice presidential running mate in 2012. To this point, Ryan has said he has no interest in the job, which shouldn’t be surprising, given the contentious crew of mainstream Republicans and Tea Party types he would have to herd. (The treatment of Boehner was just slightly less hostile than what was meted out to early speakers of Britain’s House of Commons; seven were beheaded between 1394 and 1535, although that was not the doing of their fellow MPs, but rather of the king.)
A default would be a decapitation of sorts of the U.S. Treasury’s obligations, which stand at the head of the worldwide capital markets. The impact of America’s failing to pay its debts in full and on time is literally inestimable, given Treasury securities’ role of linchpin of the global financial system.
Politics, not finances, are the main risk to the unrivaled status of the credit of the U.S. In an affirmation of its triple-A rating on U.S. government obligations, Moody’s Investors Service dryly said last week that “uncertainty can arise from the contentiousness of the political process.”
The dysfunction in D.C. was a major reason for Standard & Poor’s shocking move to remove its triple-A imprimatur from the U.S. government’s obligations in 2011. Despite all of the ill-informed hysteria at the time that interest rates would shoot up on Main Street, nothing of the sort happened.
The ability of the U.S. to issue IOUs that are the favored asset of the rest of the globe, and that are denominated in the world’s main reserve currency and used as a store of value, as well as for trade and financial transactions, is an astounding advantage. Imagine if we were on a gold standard, and we had a mine with infinite reserves that could be extracted for zero cost. That is what the U.S. has with its ability to print dollars and issue Treasury securities.
To be sure, that’s an invitation to abuse what has been called an “exorbitant privilege.” That privilege can be maintained only to the extent that it is restrained. Indeed, Moody’s points out in its report, political wrangling has “introduced an element of spending restraint which has contributed to deficit reduction ahead of our expectations in recent years.”
But the debt-ceiling charade, in which Congress decides whether to borrow to pay for the spending it previously approved, is the height of hypocrisy. And it runs on both sides of the aisle. As Chris Krueger of Guggenheim Partners points out in a research note, “Recall that then-Senators Biden, Clinton, Kerry, and Obama voted against [raising] the debt ceiling when George W. Bush was president.”
Even if Boehner manages to get a debt-ceiling increase through the House, Krueger says passing it in the Senate is “possible and probably doable, but it is no slam-dunk.” Democratic leader Harry Reid’s help will be needed because many GOP senators won’t go along, and it will take 60 votes to pass.
“This issue will put all the 2016 presidential candidates under intense pressure from the business wing of the party to support a clean debt-ceiling raise and intense pressure from the Tea Party wing to oppose (Marco Rubio is probably in the toughest position),” he adds.
With the speaker selection, the budget process, the fate of the Export-Import Bank, and the debt ceiling all coming to a head, “you have the political equivalent of a dumpster fire,” Krueger concludes.
The irony is that the hottest ticket on Broadway is for Hamilton, a musical about the first Treasury secretary, who secured the credit of the young nation by consolidating the Revolutionary War debts incurred by the states. Maintaining the full faith and credit of the U.S. is vastly more important to the legacy of Alexander Hamilton than whether his visage continues to appear on the $10 bill. It would also be a way for life to imitate art in a good way.
NONE OF WHICH KEPT the stock market from having its best week in some time. Going into Friday’s session, global equity markets’ valuations were enriched by some $2.5 trillion, according to Bloomberg calculations. As for U.S. stocks, Wilshire Associates reckons that they tacked on 3.44%, or approximately $800 billion, over the full week, based on the gain in the Wilshire 5000 index, their biggest weekly gain in nearly 12 months.
Have bulls stampeded back into stocks? Not according to the strategy team at Bank of America Merrill Lynch, led by Michael Hartnett. In the latest week, equity funds had redemptions of some $4.3 billion, while fixed-income funds saw $2.4 billion exit. But money-market funds yielding essentially zilch garnered a massive $53 billion. The surge in cash equivalents indicates that the big rally in risky assets was “driven primarily by short-covering, rather than fresh risk-on” positioning, they write.
The headlong rush into money markets inspired a couple of curious effects. The U.S. sold three-month Treasury bills at a yield of absolute zero—0.00%—for the first time. T-bills have traded at negative yields in the secondary market previously.
Lending to Uncle Sam for bupkis isn’t unreasonable, given that the European Central Bank charges banks a fee to stash their cash there. In contrast, U.S. banks can earn 0.25% on their idle cash at the Fed. But we can’t get that deal, so T-bills go for zilch.
This bizarro world of zero interest rates has gone still further, which is evident in the esoteric realm of options on eurodollar futures, through which banks and other institutions bet and hedge on the future level of the London interbank offered rate, the key money-market benchmark. So, somebody bought call options, betting that Libor would be zero next year, down from 0.3196% currently.
That would imply that the federal-funds rate would be below zero, versus the Fed’s 0% to 0.25% target range, which is universally expected to rise, if not by year end, then in 2016.
John Brady, managing director at R.J. O’Brien, a major Chicago futures broker, cautions that the purchase of call options for 0% Libor may have represented a hedge on some mind-bogglingly complex derivatives transaction. Yet the mere need to take out insurance (which is what options are, in essence) against negative interest rates, and pay a premium for it, implies something weird.
Still, markets rallied, no doubt boosted by renewed expectations that a Fed rate hike is a 2016 event, even as central-bank officials and many economists cling to the idea that liftoff could take place before year end.
Regardless of the outlook for monetary policy, clients of Louise Yamada Advisors were tipped off last weekend about what to expect in her monthly report titled, “Bear Market in Progress; Rally at Hand?”
While Louise contends that the highs of the six-year bull market have been seen, bear markets usually feature rallies. Even without speculation about the Fed’s deferring liftoff, she spied trends in the market that pointed to bounces in deeply depressed materials and energy stocks ahead of last week’s rebound. As for the latter, the Energy Select Sector SPDRxle in Your Value Your Change Short position exchange-traded fund (ticker: XLE) jumped 8% last week.
The move could take the S&P 500 to the 2050 to 2060 range and the Dow Jones industrials to 17,500—from Friday closes of 2014 and 17,084, respectively—but long-term sell signals remain in place. In her monthly missive, Louise writes that the risk is for a retracement to the levels where the major averages broke out from their long-term trading ranges in 2013. In round numbers, that would be back to 14,000 on the DJIA and 1600 on the S&P 500.
“Traditionally, rallies in bear markets, if we’re correct on that, can cause a return to complacency before the bear claw comes out again,” she related in an e-mail on Friday. Her key message to her clients: “Capital preservation remains key.”
Good advice, as the market provides higher prices for losers, which are tax-loss candidates, and winners, as well.