The main reason for last week's massive market surge on nothing but hope, if no actual deal, is due to the market's now habituated response that no matter what happens in Congress, there will always be a last minute deal. After all this was the pattern with the 2011 government shutdown and debt ceiling deal, and the 2012 fiscal cliff solution: surely enough points to make a pattern. However, as Goldman's Alec Phillips points out, 2013 may be different: "First, Congress allowed sequestration to take effect on March 1, despite the expectation among many observers earlier in the year that the cuts would be pushed off in light of the predicted the negative practical and economic effects that might result. Then, two weeks ago, Congress allowed the government to shut down. For the second time this year, the expectation of a last-minute deal turned out to be incorrect."
More from Goldman:
Since 2011, split control of Congress has led to greater policy uncertainty, but fiscal deadlines always seemed to end with a last-minute resolution. For example, in early 2011, amid a dispute over spending levels and after several short-term extensions of spending authority, Congress nearly allowed spending authority to lapse. This would have resulted in a government shutdown, but it was avoided at the last minute (agreement was reached at 11:15 pm, just short of the midnight deadline). Over the following two years, Congress avoided several possible shutdowns by passing another eight “continuing resolutions” to extend spending authority. The “fiscal cliff” was also averted following a last-minute deal, as was the 2011 debt ceiling debate.
This year has been different. First, Congress allowed sequestration to take effect on March 1, despite the expectation among many observers earlier in the year that the cuts would be pushed off in light of the predicted the negative practical and economic effects that might result. Then, two weeks ago, Congress allowed the government to shut down. For the second time this year, the expectation of a last-minute deal turned out to be incorrect.
After reaching agreement ahead of (or slightly after) so many deadlines over the last couple of years, the failure to address sequestration and the government shutdown could be interpreted to suggest that conventional wisdom that Congress always reaches a last minute agreement is now broken. This interpretation is likely behind the market reaction ahead of the debt limit deadline.
While there is an element of truth to this—some lawmakers have begun to shrug off the warnings of negative consequences from missing fiscal deadlines—we believe the shutdown occurred and the sequester took effect possibly because Republican leaders viewed it as necessary in order to ensure an increase in the debt limit. This is why we have held the view that while the shutdown was a negative development in its own right, it did not imply greater risk to the debt ceiling hike, and might have even reduced the risk.
So what does this mean for the path ahead? We interpret the events over the last year to mean that while Congress has become increasingly willing to allow more incrementally negative policy outcomes like the shutdown and the sequester, the debt limit still represents a line that Congress is not willing to cross.
Maybe. Then again, if the increasingly prevalent thought that the US can shoulder a prioritization of payments without actually defaulting by satisying interest payments if not non-critical payments that are not supported by incoming tax revenues, the debt ceiling deadline could mean the third time is the hardly the charm when it comes to crossing critical D-Day headlines. Very much to what would be the market's complete shock and horror.