Are Markets Sleepwalking Into A Debt Ceiling Crisis: Mnuchin Issues Another Warning

Over the weekend, Morgan Stanley reminded its clients that perhaps the biggest threat facing markets over the coming weeks is the “three-headed policy monster” inside Washington: raising the debt ceiling, passing a budget and embarking on tax reform. As MS cross-asset strategist Andrew Sheets noted, "none are easy, but we see the debt ceiling as the most immediate test."

He then cautioned that while the most likely outcome is that, after some tension, the debt ceiling gets raised "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 prioritization 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 prioritization 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."

Perhaps sensing that the market is getting increasingly concerned about the potential standoff over the debt ceiling debate, which could eventually lead to a technical default, moments ago Treasury Secretary Steven Mnuchin, speaking at an event in Louisville, said that "we need to raise the debt limit and it’s my strong preference is that there’s a clean raise of the debt limit."

While Mnuchin conceded that he is "all for spending controls” and Congress has the “absolute right and the absolute obligation” to oversee spending, the Treasury secretary issued another stark warning that "he’ll run out of authority by end-Sept. to stay under the debt ceiling." Said otherwise, Congress will have just days to reach a compromise on the debt ceiling when it returns from recess.

Assuming that Mnuchin is correct, and that the D(ebt)-Day actually falls in September, that would mean that the T-Bill kink noted previously will shift forward, most likely to the last week of September.

Potentially complicating matters is that as Morgan Stanley observed, the fact that "debt prioritization" remains an explicit option laid out by the Fed in 2011, may be just the reason why Congress will take its time, assuming that there is a loophole to a last minute deal as neither side rushes to comrpomise, which in turn could lead to the dreaded outcome, however short it may be.

Mnuchin also added redundantly that "we can’t put the credit of the United States on the line” as reserve currency of world and major economy." This is a continuation of what Morgan Stanley said: "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."

History may be watching, but most markets so far are not?

Recall that when it comes to discounting any potential complications over the coming debt ceiling showdown, US T-Bills have been well ahead of the broader "Wall of Worry", as shown both above and in the charts below.

Indeed, the dislocation in front-end rates deemed “at risk” given the likely timing of any missed or delayed payment should persist right up until there is a resolution, with the pricing of risk becoming more pronounced the longer there is inaction. But when will remaining asset classes follow and start selling off on fears that an 11th hour solution won't be reached?

Judging by historical examples, "it is not unusual for equity markets to be comparatively sanguine until it is within the month of the deadline", according to Deutsche Bank.

In 2011, the VIX oscillated somewhat in the months ahead (with modest rises at a roughly similar lead to the debt ceiling deadline as the current rise in vol), but the meaningful move higher did not come until about a week prior to the eventual resolution. In 2013 (when the debt ceiling deadline coincided with a government shutdown), the larger pop in equity vol occurred about three weeks before, peaking about a week prior to the resolution. It has not been uncommon to see some degree of equity drawdown about two months ahead of the debt ceiling deadline, with another more muted sell-off arising alongside with the aforementioned rise in volatility, though through this lens the evidence is perhaps somewhat less conclusive.

In other words, while the market has shown remarkable complacency so far and stayed stoically sanguine about the late September debt ceiling fireworks, this may change very soon. Deutsche Bank's conclusion:

September presents itself as a possibly pivotal month during which Congress must pass a new budget and raise the debt ceiling and the Fed may still yet press ahead and announce the start balance sheet normalization. It would seem that if the Fed declines to acknowledge the possibility that more pervasive inflation weakness may warrant a pause, and political gridlock persists, dragging negotiations to the brink, the type of self-reinforcing vol spike and risk-off may not be far off.

Comments

lester1 Mon, 08/21/2017 - 13:25 Permalink

Debt ceiling crisis, or any other crisis be damned. The Federal Reserve will continue buying stocks covertly to keep the assets of the wealthy propped up! Stop by 33 Liberty Street NYC  and say thanks to the NY Fed keeping Markets propped up.

whatswhat1@yahoo.com Mon, 08/21/2017 - 13:26 Permalink

Will the S&P tank during the eclipse or will the algos be able to "keep the show on the road"?  We shall see.  Wish I manufactured a few million Chinese eclipse glasses last December.

besnook Mon, 08/21/2017 - 13:31 Permalink

this is such bs. there is no advantage to anyone in congress to not raise the debt ceiling. we will get the usual grandstanding about the debt and platitudes about reponsible fiscal policy. there will be party blaming and few guys who game the event by voting against a rise in the ceiling. however, the debt ceiling will be raised because western civilization depends upon it. there will not be any banksters begging for a bailout.

wmbz Mon, 08/21/2017 - 13:35 Permalink

This Muchkin guy needs to find something else to worry about. The debt ceiling is not one of them.It only goes one way...UP!

hxc wmbz Mon, 08/21/2017 - 15:21 Permalink

Mnuchin is actually a good guy (unlike Cohn) and has already experimented with running the Treasury all the way down to $0. I think Trump may use a debt default to restructure what we owe, and to whom.Rand's (really Ron's) bill's passage would assist in that effort greatly

In reply to by wmbz

Herdee Mon, 08/21/2017 - 13:43 Permalink

There's well over $100 Trillion of unfunded liabilities going forward with no plan to pay for any of it. Those are so-called obligations like military pensions etc.

Son of Captain Nemo Mon, 08/21/2017 - 13:55 Permalink

"... it is not unusual for equity markets to be comparatively sanguine until it is within the month of the deadline."

Inside Steve Mnuchin's fucked up skull. ...

AND SPEAKING OF "DEADLINES" To Russia and China: SEND U.S. $5 TRILLION OF YOUR HARD ASSETS NOW OR WE START WWIII WITHIN 1 MONTH!

Rebelrebel7 (not verified) Mon, 08/21/2017 - 15:20 Permalink

It is really a shame that the entire government and federal reserve are intent on destroying America! It is treason, and we are helpess.

turkey george palmer Mon, 08/21/2017 - 15:20 Permalink

Sounds scary. We need a distraction. Cause people just can't be allowed to hear what's going on. It's almost tempting to say I hope it goes full retard, maybe ole maverick mcpain will do something stupid or Bernie might say the wrong thing. Somebody better throw up on all this and scare the banks a little

Phillyguy Mon, 08/21/2017 - 16:30 Permalink

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The US economy is a house of cards dependent upon ever increasing debt. See- dailyreckoning.com/stockman-horrendous-storm-stocks/

surf@jm Mon, 08/21/2017 - 16:56 Permalink

How short memory is.......The repubs passed all the pork barrel spending last time with DEM majorities......It will happen this time also.....