July 26, 2011
- Washington officials are clearly continuing to play the blame game on each other.
- Lost in the dueling geopolitical battle last night was the fact that the two rival plans now on the table in Washington are actually similar, with no tax increases included in either plan.
- We continue to believe that a default by the U.S. Treasury will be avoided; however, the new wrinkle in the debt battle is the increased likelihood of a credit downgrade by at least one of rating agencies.
- A downgrade could mean an increase in the 10-year Treasury yield of 25 basis points or more, with potentially more troubling ramifications down the road.
In typical political fashion, the battle in Washington got uglier late last week, as negotiations broke down last Friday. Near term, the capital markets, particularly the long-end of the Treasury market and the dollar, will likely be a hostage to the ineptness in Washington. We strongly believe that a compromise will be made, possibly in an overtime session in August. The good news is that the negotiated plan that will ultimately be approved will place only a token drag on economic activity. The bad news is that both deficit plans fall significantly short of what is needed to address our longer term budget deficit challenges. Although we praised the work of the Bowles-Simpson commission, and believe the framework announced by the Gang of Six last week would have been excellent starting points for a true improvement in our nation’s structural deficit problems, the two remaining plans up for discussion in Washington fall short of the marks needed to address our long term fiscal challenges. Accordingly, the rating agencies are likely to have problems with both proposals and the end result may very well be a downgrade of our nation’s AAA credit rating by at least one of these entities.
The talks between President Obama and House Speaker Boehner on a substantial deficit reduction plan broke down Friday night. Moreover, the weekend of meetings, conference calls and media appearances last night, suggest that the two parties are still far apart on a plan to increase the debt ceiling and reduce the budget deficit. Republican and Democratic leaders are playing party politics and to the untrained eye the budget negotiations process has clearly deteriorated. However, the leading Democrats appear to be caving into the “Republican framework” as Senators Reid and Schumer took revenue enhancements (tax increases) off the table in the Senate’s plan, suggesting that a watered-down deal will eventually be formulated and approved.
On the Republican side, House Speaker Boehner proposed a two-part plan: The first part consists of $1.2 trillion in spending cuts (all discretionary outlay reductions) over 10 years, along with a slightly smaller increase in the debt ceiling, which would fund the government until about the end of 2011. The second part of the Boehner plan would require a new joint Congressional panel to formulate deficit reduction measures, including an additional $1.8 trillion in spending cuts over the next 10 years. This would include cuts to entitlement spending and increased revenues through an overhaul of the tax code, with recommendations to be submitted late this year.
Once Congress agrees to a set of longer term deficit reduction measures, a larger increase in the debt ceiling of $1.5 trillion or slightly more could then be approved. Boehner's plan would require Congress to vote on a balanced budget amendment before year-end. With the exception of the balanced budget amendment, this second plan sounds a lot like the establishment of a working group similar to the work done by the “Gang of Six” that was rejected by Boehner last week, but with a new committee that would also include an equal number of House members from each party. As for the balanced budget amendment proposal, even if Congress were to vote for such action it would not become binding until an overwhelming majority of the states approve it, a process that could take several years and thus, does little to address the current debt limit and budget deficit problem.
On the Democratic front, the President has stated that he would veto any measure that only increases the debt ceiling through the end of this year. Moreover, some of the rating agencies have argued that a short term compromise will fuel a credit downgrade. Meanwhile, Senate Majority Leader Reid introduced a competing plan to the Senate late Monday afternoon. This plan calls for about $2.7 trillion in spending cuts and a $2.4 trillion increase in the debt ceiling, without raising new taxes. In similar fashion to the Boehner plan, Reid’s proposal calls for $1.2 trillion in discretionary spending cuts. The remainder of the spending reductions would come from larger cutbacks in defense spending including the assumed savings from winding down the wars in Iraq and Afghanistan, which, in the view of many market participants, are not true spending cuts given that they are likely to happen anyway.
The Senate plan does not include enforcement mechanisms that are included in the House plan, but this should be open to negotiations. Both plans call for the creation of a new joint Congressional committee to meet to address longer term deficit cutting issues. The most significant difference between the two plans is that the House plan has a two-step process, which currently is a deal-breaker for the Democrats and potentially a big problem if the U.S. wants to keep its AAA credit rating. Differences such as the balanced budget amendment should not be a deal breaker, but the scope of defense versus non-defense spending cuts could be somewhat more challenging. Moreover, several Democrats will have problems that both plans do not incorporate revenue (tax) increases. Interestingly both Boehner and Reid will have a challenge selling their plans to their respective party members.
Behind the scene steps are being taken to avoid default. The Treasury is likely to begin to prepare for a shutdown of non-essential government offices by the end of this week and several of the unconventional measures we discussed in our earlier commentaries could be implemented to avoid default. This is likely to include a reduction in cash balances and asset sales, including possible liquidations from the “social security trust fund”. Late Monday, the Treasury announced a sizeable reduction in the size of its upcoming Treasury bill auctions to free up issuance space for the August 15 coupon refunding issuance. These measures, along with better than expected corporate tax receipts, will buy the government some time, possibly until the first week of September. If an agreement cannot be reached this week, the government will not default but Congress will appropriately have to cancel its summer recess vacation and face the increased likelihood that the government’s debt rating could be downgraded. As a side note, if the government shuts down non-essential offices this is likely to include the closing of the Commerce and Labor Departments which will likely delay the release of many of our upcoming economic releases in early August.
When all is said and done our political leaders will pass a new debt limit. However, we are not as optimistic that the U.S. can maintain its triple-A rating. Moody’s, Standard & Poor’s, and Fitch have all warned that they might cut the credit rating on U.S. debt. For example, S&P stressed that the U.S. would need a $4 trillion package to keep its triple-A rating—a target that is not met by either plan. The ratings agencies have made it clear that raising the debt ceiling alone might not prevent a credit downgrade and are still touting that our Washington leaders need to make significant progress on legislation to reduce the deficit over the long term to keep our premier ratings status. The short-term aspect of part one of the Boehner plan could trigger a rating downgrade. Likewise it is unclear if Reid’s plan offers enough to tackle our nation’s long-term fiscal challenges. A debt deal that ties further cuts to another vote later this year or next year is likely to increase the likelihood of a downgrade in our nation’s credit rating.
We continue to believe that the framework in either the Bowles-Simpson plan or the Gang of Six plan announced last week offers the best chance of addressing our nation’s long term budget deficit challenge and keeping our AAA credit rating. Unfortunately, these somewhat similar plans require the ability of our Washington leaders to compromise and accept both significant cutbacks in spending (opposed by the liberals) and selected tax increases (opposed by the tea party), both of which are no longer on the table.
At this juncture, the most likely outcome is that our Washington leaders will reach a compromise for a modest extension of the debt limit. This, in turn, will probably be followed by a ratings downgrade by at least one of the major ratings agencies. Judging by the fact that 10-year Treasury yields are less than three percent, the risk for a credit downgrade does not appear to be built into either the level or the term structure of the Treasury market.
The big question is how much impact could a credit downgrade have on Treasuries? If we use corporate bond spreads and the events in Japan as a guide, a downgrade from AAA to AA is probably worth at least 25 basis points. However, if it comes in the dog days of summer the reaction could be greater as it would likely place added downward pressure on the dollar, which could weaken the much-needed foreign investment in the U.S. Treasury market.
A credit downgrade, if realized would likely have negative ramifications for the greenback, but could provide support to commodities that will be priced in cheaper dollars for emerging market economies. Even if the U.S. debt is downgraded the U.S. dollar would still be the world’s reserve currency. A credit downgrade could raise jitters and volatility in the equity market. However, the continued release of generally strong earnings (of the 164 companies that have released their results as of mid-day on July 26, almost 80 percent have provided upside surprises on the earnings front and 73 percent have bested the forecast for sales), should provide some underlying support for equities near current levels.
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