SocGen On The Three "11th Hour" Debt Ceiling Scenarios, And Their Respective Market Reactions

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As we enter the overnight futures market open, there is still no resolution on the ongoing debt ceiling open question. Which is why we present SocGen's handy summary of the three scenarios that are currently in the running for a consensual resolution, together with the possible market reactions to each. The three plans are the McConnell-Reid plan, which as per latest news is in the frontrunning currently, not least (and probably only) due to the immediate beneficial impact it would have on stocks. The 2nd plan is a large deficit reduction plan, whose primary impact would be a significant drag on GDP. Stocks, and bonds, are likely to both rally on the news of this plan, at least in the short-term until the market realizes that some economic growth is actually necessary for the hopium illusion to continue. Lastly, the worst case outcome is no increase in the debt limit, which, logically, would mean that every illusion collapses and the emperor is finally exposed to be naked.

From SocGen: US debt ceiling scenarios at the 11th hour

We are heading into overtime in the debt ceiling debate. The news flow will be fluid this upcoming week, and as a result markets could be volatile. While a long term deficit reduction plan that is attached to a large increase in the debt ceiling is the ideal outcome, a small increase in the debt ceiling remains the baseline scenario. The Senate could begin moving on the McConnell-Reid plan this week in order to get the debt limit raised before the Aug 2 deadline. Market reaction to the various outcomes could vary with the response to a technical default the most intriguing.

The debt ceiling fiasco is coming down to the wire. There is about a week left to the August 2 deadline in which the Treasury says its accounting trickery will run out and the US will enter into technical default. Parties continue to try to negotiate a long term deficit reduction deal. But reports suggest that the ideological divide remains too wide to close in time to attach a large scale debt deal to an increase in the debt ceiling. We continue to believe that the most likely scenario is a last minute deal to increase the debt ceiling with very little in agreed spending cuts. We have to consider the potential market impact of this outcome as well as two other scenarios, including an increase in the debt ceiling coupled with substantial deficit reduction; and no increase in the debt ceiling.

McConnell-Reid Plan. This is multiple stage plan which sees the debt ceiling increased by $100bn immediately followed by much larger increases in the future which are tied to matching spending cuts. The total debt ceiling increase is said to be $2.5tn. If there is no progress on a long term package, we could see the Senate begin moving on this plan early next week.

Market considerations. We could see a rally in stock markets, as it could remove some of the uncertainty hindering the economic expansion. The University of Michigan confidence survey asks a specific question about government policies and that assessment deteriorated sharply in July. According to our models, if sentiment reverses after the raising of the debt ceiling payroll growth should return toward a 150k-200k range by the fourth quarter.This is only enough to support a snailpaced Fed exit, but it will fall far from the Fed’s easing threshold which remains very high in our view. While stocks may rally, the impact on Treasuries is more uncertain as a small increase in the debt ceiling still keeps the door open to a credit rating downgrade from Standard and Poor’s.

Large Deficit Reduction Plan. There are a number of plans on the table including the $3.7tn package from the “Gang of Six” which includes Senators from both parties. As well, negotiations are ongoing between the White House and Congressional leaders. Time is short and the partisan divide is likely still too great for one of these plans to pass.

Market considerations. The market reaction to news of a grand plan could be similar to the reaction we saw when both stocks and the long bond rallied on the news of the “Gang of Six” plan.

We also have to remember that large scale austerity measures could be a major drag on GDP over the next ten years. Our simulations using the President’s Debt Commission plan showed that in 2013 the cuts could shave 0.4pp to 1.4pp off growth and by 2020 the drag could be even greater, at 1.4pp to 5.1pp. This is illustrated in the fan chart on the previous page. The red line is our baseline forecasts and the grey area is the
range of possibilities for growth if there is a large-scale fiscal austerity package.

This could also mean that expectations of monetary policy may shift. Relative to our central scenario, which sees the overnight rate rising toward 4% by 2015, the austerity scenario sees the Fed leveling off at 2% and pausing afterwards. While some of the fiscal drag will be partially offset by lower bond  yields and a “crowding-in” effect, the Fed will nonetheless have to lean against the wind.

No Increase in the debt limit. We continue to see this risk as very small particularly given the fact that President Obama has sent signals that he would adopt the McConnell Reid plan as the path of last resort. That said, if there were no increase, it would result in the US entering into a technical default and this would be followed by a downgrade to its rating by credit ratings agencies.

Market considerations. Intuitively, we would assume that Treasuries would sell off in the event of a technical default. But there is growing sentiment  that this may not be the case. The sensitivity of equities to the fiscal situation is greater than that of Treasuries. As a result, under a technical default  there could be a large sell off in equities and we could see Treasuries rally as investors flee to safety. It is also worth noting that government spending could contract in the event of a technical default. The contraction would be in the magnitude of 10% of GDP annualized if the stand-off lasts from August to September. This could risk putting the US back into recession; hence an equity sell-off and Treasury rally. Chatter suggests there is growing belief that this is the reaction expected by markets in the case of no increase in the debt ceiling.