Tuesday, October 15, 2013 - Downgraded and Defaulted

Downgraded and Defaulted
by Sinclair Noe

DOW – 133 = 15,168
SPX – 12 = 1698
NAS – 21 = 3794
10 YR YLD + .03 = 2.72%
OIL – 1.49 = 100.92
GOLD + 7.70 = 1282.00
SILV + .03 = 21.40

For most of the day the Dow Industrials were drifting just a little lower but as the afternoon dragged on it became more and more obvious that the politicians in Washington are still dysfunctional and signs of progress towards a resolution on the debt ceiling remain illusory. The House of Representatives started the morning with yet another plan that had no chance of success, and they were essentially sent back to the drawing board. Selling accelerated during the afternoon after Senator Richard Durbin said Senate negotiations had been suspended until House Speaker John Boehner can work out a fiscal plan that can proceed in the House of Representatives.

Losses were broad, with all 10 S&P 500 sectors falling on the day. Three-fourths of stocks traded on the New York Stock Exchange ended lower while 68 percent of Nasdaq-listed shares fell. The situation in Washington has driven trading lately, overshadowing the beginning of a busy week of earnings. Citigroup Inc reported weaker-than-expected results as the bank was hit by a double-digit drop in bond trading revenue for the quarter. Johnson & Johnson reported stronger-than-expected quarterly results on strong growth for its prescription drugs, while Coca-Cola Co reported revenue slightly under expectations. Intel reported revenue that topped expectations. CSX Corp and Yahoo Inc both also rose after posting results after the close. Since the government shutdown 2 weeks ago, the markets have dropped, then we had a few days of recovery, and the net change pretty much a wash. But now we're running out of time.

Fitch Ratings has placed the United States of America's 'AAA' Long-term foreign and local currency Issuer Default Ratings on Rating Watch Negative. The Rating Watch Negative would be a step toward cutting the credit rating. Fitch says it believes that the debt ceiling will be raised soon, but the political brinkmanship and reduced financing flexibility could increase the risk of a default.

The current 'AAA' rating also reflects the halving of the federal budget deficit since 2010, which is now approaching a level consistent with debt stabilisation.  The prolonged negotiations over raising the debt ceiling (following the episode in August 2011) risks undermining confidence in the role of the US dollar as the preeminent global reserve currency, by casting doubt over the full faith and credit of the US. This "faith" is a key reason why the US 'AAA' rating can tolerate a substantially higher level of public debt than other 'AAA' sovereigns. The repeated brinkmanship over raising the debt ceiling also dents confidence in the effectiveness of the government and political institutions, and in the coherence and credibility of economic policy. It will also have some detrimental effect on the US economy.

So, that's the latest blast from Fitch. If we hit Thursday without a deal, the best estimate is that most people wouldn't immediately notice the government has hit the debt ceiling, not right away. The government by law will no longer be able to add to the national debt, and will have to rely on incoming revenue and about $30 billion in cash to pay the nation's many obligations. Unless Congress raised the nation's debt ceiling, the money would be gone within days.

Some people claim the government is out of money, which is kind of silly. The government creates money; all the government has to due is issue bonds and the Federal Reserve will create the money. So the only way we can really be out of money is if we artificially say we will stop creating money; and right now, that seems to be the deal. You've heard the analogies of how the US budget is like a family budget, and the family ran up debt on the credit card. That's not true. The government is not like your family; the government can create money out of thin air; the government has a printing press. And on Thursday, the government faces the prospect of turning off the printing press.

That means the government will have to rely on incoming revenue and about $30 billion in cash to pay the nation's many obligations. Unless Congress raised the nation's debt ceiling, the money would be gone within days. The Congressional Budget Office estimates Washington would start missing payments between October 22 and the end of the month. America could miss a $12 billion payment due to its Social Security pension program on October 23. And with a few missed payments the economy will freeze up and lock up and grind to a halt.

It might happen before then. The political dysfunction would likely lead to a sharply diminished appetite for risk, which in turn would undermine equities; expect stocks to take a big hit. Sentiment for safe haven assets have already started to sour. In recent days, major money market mutual funds, including Fidelity, JPMorgan and Pimco; have started shunning US debt that comes due between October 17 and the middle of November.

Also, US Treasuries are used as collateral for trillions of dollars of financial deal; any default changes the understanding of that collateral and would likely result in massive defaults. Remember that a big chuck of those deals are also backed by derivatives, such as credit default swaps. If default triggers those swaps then the problems intensify exponentially. The problem with Credit Default Swaps are that they are used like a form of insurance, but unlike insurance the sellers don't have reserves in place to pay for claims in the actual event of a default. So, if there is a default, then everything freezes because nobody will know what anything is worth.

So the big question is whether the politicians will screw this up and default, or as the New York Times described: “a legislative failure and an economic catastrophe that could ripple through financial markets, foreign capitals, corporate boardrooms, state budget offices and the bank accounts of everyday investors”.

There is a reasonable argument that we've already started defaulting. Right now, with the shutdown, we’ve already reached the point at which the government is breaking very important promises indeed: we promised to pay hundreds of thousands of government employees a certain amount on certain dates, in return for their honest work. We have broken that promise. And the fact that many firms have stopped buying and sold short-term Treasuries also means the global faith in US institutions has already been undermined. The pieces of the catastrophic puzzle are in place.

And that means that economic growth will be slower than it should be, unemployment will be higher, unrest will grow. This government-by-crisis approach has cost the economy about 900,000 jobs and raised the unemployment rate by about 0.6 percent, according to a study by private forecasting firm Macroeconomic Advisers, commissioned by the Peter Peterson Foundation. Macroeconomic Advisers said in a press release: "Partisan divided government has failed to address our long-term fiscal challenges sensibly, instead encouraging policy that is short-sighted, arbitrary, and driven by calendar-based crises.”

Macro Advisers estimates that the government shutdown has already shaved about 0.3 percent from economic growth in the fourth quarter. A short debt default, starting Thursday and wrapping up within a few days, before any actual non-payment occurs, could cause unemployment to spike to 8.5 percent from 7.3 percent and cost 2.5 million jobs, Macro Advisers estimates. A longer default, lasting a couple of months, would cause an even deeper recession, pushing unemployment to 8.9 percent and costing 3.1 million jobs. All of this has weighed on economic growth -- which in turn has made government finances worse than they needed to be. Macro Advisers estimates that the austerity of recent years has cut GDP growth by 0.7 percent and cost 1.2 million jobs already.

While debt default is undoubtedly the worst of all possible worlds, then, the bonkers level of Washington dysfunction on display right now is nearly as bad. Every day that goes past is a day where trust and faith in the US government is evaporating — and once it has evaporated, it will never return. The Republicans in the House have already managed to inflict significant, lasting damage to the US and the global economy — even if they were to pass a completely clean bill tomorrow morning, which they won’t. The default has already started, and is already causing real harm. The only question is how much worse it’s going to get.

So, here's where we stand. On a day of political drama and confusion, House Republicans first proposed their own version of a Senate plan to temporarily end the political stalemate paralyzing Congress, then haggled among themselves over the details before finally agreeing to vote on it Tuesday night.

But shortly after announcing the planned vote, the House committee that sets the rules for such procedures postponed its hearing. There are some indications that the GOP leaders are struggling to round up the votes. Another factor is that apparently the conservative groups Heritage Action and Freedom Works came out against the plan. So, for now it looks like there will be no House vote today.

The conservative groups both said they will "key vote" a bill that was expected to hit the House floor Tuesday night.  Heritage Action said in a statement: "Unfortunately, the proposed deal will do nothing to stop ObamaCare’s massive new entitlements from taking root — radically changing the nature of American healthcare."