Morgan Stanley: Here Comes "The Three-Headed Policy Monster"

Tyler Durden's picture

One month ago, Morgan Stanley's chief cross-asset strategist looked at the current state of the market - "the S&P 500, Russell 2000 and NASDAQ have hit all-time highs. Volatility has plunged back down near all-time lows. Credit is tighter and yields have been stable" - and asked "what rattles this market. What breaks the egg?"

His answer was five-fold, including valuations, inflation, geopolitics and China, but the biggest concern was what is coming in just one month on the US legislative docket:

The debt ceiling worries us most, given that action may need to be taken within as little as seven weeks.

It was "seven weeks" four weeks ago, which means that the D(debt)-day for the US government - now expected ti hit in the first days of October - is ever closer, even as the domestic political situation in the U.S. gets progressively worse.

So where are we now?

Predictably, as Sheets writes in today's latest weekly Sunday Start, "political risk is rising on our list of concerns, after a limited (negative) impact so far this year", and while the MS strategist is concerned about the UK, he is increasingly more worried about the US: "In the US, it’s the need to pass a budget and increase America’s borrowing authority so the world’s largest economy can pay its bills. The stakes are high; without the ability to issue new debt, our economists expect that the US Treasury’s dwindling cash reserves could be exhausted by mid-October" meanwhile "in the US, Congress will return Labor Day to face what my colleague Michael Zezas calls a “three-headed policy monster”: Raising the debt ceiling, passing a budget and embarking on tax reform. None are easy, but we see the debt ceiling as the most immediate test."

What happens then:

The most likely outcome is that, after some tension, the debt ceiling gets raised. But we don’t think it will be easy, or smooth, and it may require some form of market pressure to get different sides to fall in line. I’ve spoken to investors who are comforted by FOMC transcripts from 2011 that discussed prioritisation of debt payments in order to avoid default. I am not. First, I worry that this reduces the urgency of what remains a serious issue. Second, this prioritisation would require delaying payments to programmes like Social Security and Medicare, with real human and economic cost. And third, while the mechanics of this prioritisation may work, it is untested in a live environment.

In other words, the fact that the Fed has a "backup plan" for the worst case scenario, is precisely why the worst case scenario is now much more likely to happen, something that judging by the growing kink in the T-Bill curve, the market increasingly agrees with, and why the first week of October could be a major shock for risk assets.

 

Furthermore, assuming a best-case outcome, one where a clean bill passes with no problems, there is an additional wrinkle according to MS:

"in the good scenario where the debt ceiling is increased, the Treasury will need to issue a lot of paper to claw back the cash balance that’s been drained during this process. Our US economists think that this could involve US$300-375 billion of T-Bill issuance in 4Q, a level with very limited historical precedent."

While there are various trade ideas associated with that observation, Sheets ends off with a somber, philosophical adieu:

The idea that America’s creditworthiness is beyond reproach is, without exaggeration, the cornerstone of the global fixed income market. We hope that politicians appreciate the seriousness of this issue and put politics aside to resolve it. History is watching.

And on that note, here is Morgan Stanley's full report:

One-Sided Political Risk

 

We remain constructive. But political risk is rising on our list of concerns, after a limited (negative) impact so far this year. In both the US and UK this risk looks one-sided and negatively skewed over the next month, with the best case being that it may not matter. We’d stress that this is before considering any effect on confidence or policy after a growing number of CEOs and business leaders moved this week to publicly rebuke and distance themselves from the US administration.

 

In a few weeks’ time, politicians will come back from their summer holidays to face serious challenges. In the UK, there will be increased scrutiny of the progress (or lack of) in Brexit negotiations. In the US, it’s the need to pass a budget and increase America’s borrowing authority so the world’s largest economy can pay its bills. The stakes are high; without the ability to issue new debt, our economists expect that the US Treasury’s dwindling cash reserves could be exhausted by mid-October.

 

Simple, one might say. For the UK, negotiations are still in their early stages. For the US, leaders from both parties have stated that they’re committed to raising the debt ceiling. Yet, both of these scenarios face the challenge of ‘campaigning versus governing’. We think this can matter for markets.

 

Let’s start with the UK. The idea of ‘Brexit’ was always loosely defined during the referendum campaign. But now that it’s official policy, a choice needs to be made between ‘soft’ versions that still encourage trade and ‘hard’ versions that curtail immigration sharply. Picking one will invariably disappoint some supporters, while those originally opposed to Brexit will likely remain so.

 

There is little margin for error: the government’s majority is slim, and our economists think the effective deadline for reaching a deal may be as early as October 2018 (considering the time needed for ratification by various EU member states). Having been bullish on GBP earlier this year, our FX strategists would now be sellers, expecting increased press attention on these challenges to impact sentiment. They like being short GBPSEK and GBPEUR.

 

In the US, Congress will return Labor Day to face what my colleague Michael Zezas calls a “three-headed policy monster”: Raising the debt ceiling, passing a budget and embarking on tax reform. None are easy, but we see the debt ceiling as the most immediate test.

 

You may not have realised it, but the US Treasury hit its borrowing limit in March, is unable to issue new net debt, and has been operating by running down its cash balance. Our economists estimate that those reserves will be exhausted by mid-October. Since one doesn’t want to cut this too close, this ‘debt ceiling’ needs to be raised by the end of September.

 

That won’t be easy. A subset of Republicans in the House want to make additional borrowing conditional on spending cuts (an issue they’ve campaigned on). That could be a non-starter for the Senate, where bipartisan support will be needed to reach the 60 votes that this increase needs. The fractious nature of the health care debate likely hasn’t helped the level of trust between the Houses of Congress and the parties within them. And the ability of the White House to whip key votes could be impaired by low approval ratings and the continued fallout from comments related to last weekend’s tragic events in Charlottesville, VA.

 

The most likely outcome is that, after some tension, the debt ceiling gets raised. But we don’t think it will be easy, or smooth, and it may require some form of market pressure to get different sides to fall in line. I’ve spoken to investors who are comforted by FOMC transcripts from 2011 that discussed prioritisation of debt payments in order to avoid default. I am not. First, I worry that this reduces the urgency of what remains a serious issue. Second, this prioritisation would require delaying payments to programmes like Social Security and Medicare, with real human and economic cost. And third, while the mechanics of this prioritisation may work, it is untested in a live environment.

 

There’s one more wrinkle: in the good scenario where the debt ceiling is increased, the Treasury will need to issue a lot of paper to claw back the cash balance that’s been drained during this process. Our US economists think that this could involve US$300-375 billion of T-Bill issuance in 4Q, a level with very limited historical precedent.

 

For investors, our interest rate strategists think that this should make it attractive to position for narrower 2-year swap spreads. If the debt ceiling is resolved, this flood of issuance could lead 2-year notes to underperform the swap. If it isn’t, the same result may be possible if investors temporarily avoid short-dated Treasury securities.

 

The idea that America’s creditworthiness is beyond reproach is, without exaggeration, the cornerstone of the global fixed income market. We hope that politicians appreciate the seriousness of this issue and put politics aside to resolve it. History is watching.

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DinduNuffin's picture

turn off the welfare already -- let's see where it goes

knukles's picture

What we have here is a failure to communicate

JRobby's picture

Fuck Morgan Stanley

Shut it down. Criminals.

Son of Thor's picture

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mike_king's picture

I hope the Fedgov shuts down and the world has a deflationary economic collapse. Reset everything.

Chupacabra-322's picture

"None are easy, but we see the debt ceiling as the most immediate test."

"We?"

Who's we?

You mean the Pure Evil Criminal Central Bankerster's access to free money.

bluskyes's picture

All theater. The debt is unpayable.

There are two choices for one being hanged by credt. Cut the rope, default, and live. Or die.

veritas semper vinces's picture

Not only what you so concise said.

But the debt was not meant to be paid. The economy,GDP rely on exponential expansion of the debt. This is how money is created by them.You pay off debt,you destroy their money creation as money is created as debt. Vicious circle. You don't pay it,you 're crushed by the weight of it.

Herodotus's picture

Trump should veto any legislation that increases or suspends the debt ceiling.  He needs to force Republicans to vote to override his veto.  He can then campaign to get rid of them once and for all in the 2018 Republican primaries.

Rebelrebel7's picture

If Republicans fail to raise it, it will destroy them politically,  particularly since there is a Republican president. Fine with me either way!

It's hillarious! Both parties are only marginally effective at being the opposition, since neither party is,willing to do anything that people would actually support! I wonder if these baboons will ever figure out that people will not support tyranny!

A. Boaty's picture

Paging LawsofPhysics. Full faith and credit.

wmbz's picture

"The debt ceiling worries us"

Please, tell that crap to someone else. Who in the hell gives a damn about that? When have they not raised it?

In fact they would like to do away with that little pain in the ass, once and for all.

JRobby's picture

It is in the hands of CONgress.

CONgress is infiltrated with a substantial number of foreign enemy agents.

They will do as they are commanded by their oligarch masters who have no nationality and want to collapse the USA to advance their globalist agenda.

Trade accordingly.

Maj's picture

Anyone else see this obvious battle coming? 

Congess will experience some serious hardball from Trump in regards to getting his signature on the Debt limit increase.  I mean I would expect a master dealmaker to maximize his position when he has the leverage and to get what he wants before he signs. 

That is the Black Swan coming soon to a 24 hour news channel near you.

Bam_Man's picture

"Politics is the Entertainment Division of the Military Industrial Complex."

      -- Frank Zappa

Spike the Railroader's picture
“The illusion of freedom will continue as long as it's profitable to continue the illusion. At the point where the illusion becomes too expensive to maintain, they will just take down the scenery, they will pull back the curtains, they will move the tables and chairs out of the way and you will see the brick wall at the back of the theater.”


Frank Zappa

DrumpFired's picture

Your US brokerages are fooling all of america. They will change their story by October  but it will be too late.  The only analysts we trust is Shepwave. they have only legitimate correct record over 20 years

Bammers's picture

The reccord of Shepwave speaks for itself. they are all that is left.  No one on here has any money that is why they are left to emotional bullcrap.

Chi Juan's picture

Yes Morgan Stanley is a bunch of crap. We all know that on here.  

A bunch of us here have been following Shepwave for a while and yes they have been dead on in the past.  I warn not to put too much blind faith in any market pundit.  SW does have past connections on Wall Street afterall. 

Alex Droog's picture

I see trouble in September. Big trouble. Our president has neither the attention span nor the mental accuity and emotional stability to address the biggest real problems of his first year that are fast approaching.

Bammers's picture

You don't udnerstand exactly how much control the president has do you  just one of hte clueless on the HEDGE.

algol_dog's picture

"You don't understand exactly how much control the president has"

Who's clueless?


Chi Juan's picture

His statement is correct. If you make the inference that by saying "how much control" means that he has control then YOU are obviously the cluless.  

ZeroBeek's picture

Trump has no control over White House  to start with

Sam Clemons's picture

They're just going to raise it. Trump is a turncoat so far. Why would this be any different?

PhiBetaZappa's picture

MACS0647-JD, has just agreed to accept the debt ceiling limit.

Carry on Earthlings 

ThanksIwillHaveAnother's picture

If the debt ceiling bill passes quickly, given what happened with health care, the people should conclude they are being played by the Right who will have shown there is no difference to the Left and Right except for the topics of manipulation.

FederalReserveBankofTerror's picture

Dear friends,

I wanted to let you know about a new petition I created on We the People, a new feature on WhiteHouse.gov, and ask for your support. Will you add your name to mine? If this petition gets 99,999 signatures by September 19, 2017, the White House will review it and respond!

We the People allows anyone to create and sign petitions asking the White House to take action on a range of issues. If a petition gets enough support, the White House will issue an official response.

You can view and sign the petition here:

https://petitions.whitehouse.gov/petition/permanently-reduce-federal-debt-2465000000000-one-day

Here's some more information about this petition:

Permanently Reduce The Federal Debt by $2,465,000,000,000 In One Day! 

Allow a government shutdown.
During the shutdown order US Troops to occupy the 12 branches of the Federal Reserve Bank.
Freeze selling of Treasuries by the Federal Reserve.
Freeze Selling of Mortgage backed securities by the Federal Reserve Bank.
Declare the Federal Reserve Bank a threat to national security.
Nationalize The Federal Reserve Bank.
Return the Treasuries owned by the Federal Reserve Bank to the US Treasury to be destroyed.
Turn over ownership of Mortgage Backed securities to The US Treasury.
The US Treasury will grant free and clear title to home owners who have given a mortgage which was subsequently securitized and purchased by the Federal Reserve Bank.

Conax's picture

They will raise it after making a dramatic fuss, same as always.