Debt Ceiling

DC Crisis Averted

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I don’t usually like to call the result of a game before it’s over.  But in this case I’m confident saying that the deal reached in the Senate today, which does nothing other than re-open the government through 1/15/14 and extend the debt limit to around 2/7/14, is a done deal.  The Senate is expected to vote around 6pm tonight (80+ will vote yes) and the House will vote a few hours later (I’d guess at least 65% will vote yes).  The President will likely sign the bill tonight, reopening the government by morning.

The crisis that never really was a crisis has been averted, miraculously (HA!), one day from the reported deadline.  Fear-mongering, yet again, served no purpose other than ratings and scaring people into making terrible financial decisions.  As I’ve been saying all along, there was a 0% chance of default or any permanent damage to the economy that would result from it.  Minor, temporary damage has been done though shaking the confidence of businesses and consumers, but we’ll recover from that.  However, nothing has been done to pass a budget and make the country’s long-term fiscal situation sustainable.  Over the next 3 months, which will include time off for holidays, Congress has to make some progress, or we’ll be right back in the same situation again with another “crisis” to start 2014.  We’ll see what they come up with.

For now, back to business as usual with the hopes that the last few days don’t become the new business as usual.

***Update, 11pm eastern time***

Senate passed bill 81-19 (I predicted 80+).  House passed bill 285-144 (66.4% vs. my 65%+ prediction).  Obama to sign momentarily.  Government will be open in the morning.  Debt limit extended to 2/7.  25 hours to spare from their 10/17 deadline.  Congress is getting better at this!

Quick Update On Debt Ceiling

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For those not following via Twitter, here’s what I posted today:

4pm: The storm before the calm is building in DC. Gotta take the country to the brink so they can be heroes in bringing it back.

4pm: I’d say we’re two plans away from having a plan to pass a bill that sets guidelines for developing a plan before the next deadline #cankick

7pm: Another failed plan in the House. I think we’re one away from real deal now (with little substance but will avert the “crisis”)

Still confident a deal will come right before it has to (and that’s not 10/17 as is being reported), and the US will not default on its debts.  As I’ve been saying, the result would be so catastrophic, that no one in Congress will let it go that far and the President / Treasury will use all possible measures to make sure it doesn’t happen.  Fitch ratings agency put the US on credit watch negative meaning there’s risk that they would downgrade the US Debt in the future.  Immediately after, the orchestrated response was released by Treasury explaining how Fitch’s actions demonstrate the gravity of the situation.  Everyone knows this will get resolved, but the fear-mongering will continue in the press for the next few days.

What happens beyond the agreement is a potential issue.  Further short-term agreements, followed by a “crisis”, a shutdown, a threat of default, and then a kicking of the can again in another short-term agreement, will cause a broad loss of confidence in the US government and financial system.  If we keep managing “crisis” to “crisis”, we will eventually be faced with a CRISIS.  We’re not there yet, but it’s not that far off if this continues.

If you’re not following via Twitter, I encourage you to do so as I’ll post short bursts of relevant news or a quick thought here and there.  @TomAtPWA.

US Debt Default

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More political posturing today as President Obama and House Speaker John Boehner both had press conferences to say pretty much exactly what they’ve said for the past two weeks. They’re saying it louder and more sternly each time, giving it full grandstanding effect. Obama won’t negotiate unless Republicans pass a Continuing Resolution and raise the Debt Ceiling, which is like asking them to leave all their chips outside of the poker game. Boehner won’t allow a clean Continuing Resolution or Debt Ceiling bill to be voted on in the House, even though they would almost certainly pass, without some negotiation on spending reductions or Obamacare concessions attached to it. In other words, they have a complete standoff.

I expect more of the same for another week or so, but I don’t think the sands running out of the hourglass come with a proportional increase in the chance of a US debt default. Since there is virtually no chance that a resolution will be reached until the last minute (likely a few minutes after the last minute), the probability of non-resolution should not increase as time passes. Financial markets don’t believe there will be a debt default. Countries, companies, and individuals continue to lend money to the United States at absurdly low rates (essentially 0% for a year, 1.4% for 5 years, 2.6% for 10 years, and 3.7% for 30-years!!). The chart below shows credit default swaps (CDS) on five-year treasuries in basis points. CDS pay out in full in the event of a default. 41 basis points means that people are paying 41 cents for protection on $100 of treasuries implying a four tenths of one percent (e.g. negligible) chance of default over the next five years. While slightly elevated from a few weeks ago, 41 basis points is actually about the average over the last four years, and still substantially lower than the 65 basis points during the 2011 debt ceiling “crisis”. Today, even after the grandstanding, those same CDS actually traded down to 37 basis points.

I’m not worried about a default, just like financial markets aren’t worried about it. I’m not worried about 11:59pm on October 17th either, because that is not the exact moment that a debt default would happen if the Debt Ceiling isn’t raised (ironically, the govt. shutdown has slowed spending for the last week, so there should be a bit more wiggle room). I’m confident the debt ceiling will be raised just before it needs to be raised. I really only worry about self-fulfilling feedback loops that occur in a negative direction (like the death spiral that occurs when businesses layoff workers in mass which results in less spending in aggregate in the economy which results in lower profits which results in more layoffs). I don’t worry about those things that provide a self-regulating effect. In this case, any increase in the probability of default would lead to an increase in the probability of politicians being held directly responsible for another deep recession, which leads to the sudden ability to be rational, compromise, and save their future jobs.

The stock market will continue to be jittery as program trading, momentum trading, and day trading dominate day-to-day volume and direction of movement. I have full faith that there will be no default and no permanent damage to the economy. When that becomes certain, the economy in aggregate, the actions of the Federal Reserve, and the profitability of individual companies will once again dominate the way the market is valued. I’m not making any changes to client portfolios or asset allocation models in general as result of the debt ceiling / continuing resolution “crisis”. As the old proverb states, this too shall pass.

Market Update (07-26-2011)

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*** We believe communicating with our clients is of utmost importance, especially during turbulent times in the market. While we don’t claim to have a crystal ball on the future of any financial market at a given point in time, we do believe that keeping clients informed on why things are happening increases their comfort level and understanding. This post contains a message initially sent to clients with the debt ceiling fiasco on the horizon as part of that communication effort***

Given the press coverage around the debt limit issue, I thought it would be useful for you if I gave a quick update as to what’s going on. Long-time clients will remember messages like this one that I sent frequently during the post-Lehman Brother’s bankruptcy era and around Congress’s shenanigans regarding the passage of what eventually became known as TARP. Even though no change or action is required by you, I think staying informed helps people sleep better at night during a potential crisis. So here goes…

We’ve all heard August 2nd is the deadline for raising the debt ceiling or the U.S. will not be able to pay its bills. At the same time, politicians seems to be getting further from an agreement on how to raise the debt ceiling instead of getting closer to one. Much of the press will have you believe that if the debt ceiling is not raised by August 2nd, life as we know it, will not go on and yet the urgency to raise the ceiling doesn’t seem to be there given that 8/2 is a week away. There are three things wrong with that presentation.

First, August 2nd is not the date at which the U.S. will stop paying its debts and run out of money. It is a date that the treasury secretary estimated several weeks ago based on the pace of expenditures and tax revenues. As it turns out, revenues have been higher than projected and the real date appears to be closer to August 10th. Congress is supposed to take their next recess (read: vacation) starting August 6th, so the 2nd was a much more convenient political deadline. There are also Social Security payments which need to go out on August 3rd, debt principal payments that need to go out shortly thereafter, and interest payments that need to be made to Treasury holders later in the month so that crisis is real and important. It’s just not as urgent as the talking heads would make it seem and so the lack of urgency in resolving the crisis is because there is more time that most people realize, even if it is only another week.

Which brings me to point number two. When you’re playing a game of chicken, and by all means that’s what we have here between the politicians, you always have to seem more confident in your path as you get closer to the end game. “I’m not going to move.” “I’m not going to move either… you’ll realize you’re going to move”. All the back and forth as the two get closer to a head-on high-speed collision. It’s not until the very last second that one or both parties are actually ready to move. Therefore, I expect little movement and the appearance of no chance of a deal up until the last few days of the debate. As of yesterday, both parties have put their stake in the ground followed by a stomping of their feet and a “take it or leave it” statement. The soap opera couldn’t be written any better. One or both parties will move as the threat of collision becomes imminent.

Finally, and most importantly, if the U.S. were insolvent and unable to pay its bills, a global financial catastrophe would take place well in advance of the last few cents coming out of the piggy bank. I won’t go into the goriest of details, but basically it would start a panic that U.S. Treasury Bonds were worthless (i.e. those who lent to the U.S. government would permanently stop getting their interest payments and lose their principal). This would make all of the banks and other financial institutions across the world that hold Treasuries potentially insolvent. Within days if not hours of this realization, there would be no more ATMs, no open banks, most money would be worthless, and the world economy would cease to exist. OK, maybe that is pretty gory…. Deep breath… Let’s look around though. We’re a couple of weeks away from potentially not paying our bills and none of this is happening. The U.S. Treasury today auctioned off $35 billion of 2-year notes. The annual interest rate demanded by the auction was 0.417%. That means investors were willing to lend the U.S. government $35 billion dollars today for less than a half penny of interest on every dollar each year for the next two years. Would they really do that if there were any chance of not being paid back? The answer is “no” and the reason is that the U.S. is not insolvent. People, institutions, and countries are scrambling to try to lend us money because we are the safest place in the world to put money. At that same auction, there were bidders for over $100 billion of that $35 billion in debt. The point is that even if lawmakers on both sides don’t give in (and that won’t happen) and the debt ceiling is reached (and that won’t happen) and all other avenues for paying bills are exhausted (and that won’t happen) and we really do legally run out of money because of the debt ceiling (and that won’t happen), the ramifications will be so huge, so fast, that both sides will scramble to save the day almost instantly with a simple act of raising the debt ceiling. One vote, 5 minutes to end the end of the world and this crisis is over. The U.S. is not insolvent and will pay its bills.

The bigger issue, which I’ll save for another update is far more important. We’re on a fiscal path to insolvency and unless that trajectory is corrected, our debt will no longer be the safest instrument in the world. Our borrowing costs will rise, rapidly, and the impact on the economy will be severe. Imagine the value of your house today if someone had to pay 10% for a mortgage to buy it. That has to be corrected and in principal, tackling the beginning of that correction as part of the agreement with ourselves that we’ll increase the debt limit makes some sense. But in the end, whether it happens or not, the debt limit will be raised and life will go on. Unfortunately, politics and the media’s over-dramatic reporting of those politics will go on with it.

If anything changes over the next few weeks that warrants action on your part, I’ll be sure to let you know. As always, if you have questions or comment, please feel free to contact me.

Market Update (07-14-2011)

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*** We believe communicating with our clients is of utmost importance, especially during turbulent times in the market. While we don’t claim to have a crystal ball on the future of any financial market at a given point in time, we do believe that keeping clients informed on why things are happening increases their comfort level and understanding. This post contains an excerpt from the PWA Q2 2011 newsletter to clients, sent just the end of “QE2” (Fed stops buying new treasuries), explain three key issues for a continued rebound in the economy, as part of that communication effort***

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• The End of QE – On 3/24/09, just after what we now know was the stock market bottom, I wrote in a “Market Update” note to clients that the announcement that the Federal Reserve was going to purchase U.S. Treasuries and other securities represented a “game changer” for the financial markets. Those purchases became known as Quantitative Easing (QE) with two distinct rounds of purchases being coined “QE1” and “QE2”. These were in fact a game-changer for the markets, with the S&P 500 rallying more than 100% from March ’09 to April ’11. They were a game-changer because the Fed was, in simplified terms, printing money to buy financial assets which put that newly printed money into circulation to offset the deflationary spiral that was occurring (the value of everything from houses, to bank assets, to the stock market, to commodities was falling rapidly and simultaneously causing credit markets, job markets, and the overall economy to grind to a halt). As of July 1st of this year, the Fed ended QE2 and has signaled that a QE3 is unlikely. This means the game-changer is over. However, the Fed is not selling the assets they’ve purchased to date and they will keep reinvesting in those assets as they mature which means we don’t expect a game-changer in the other direction to send the markets back down. What we do expect is that the days of 50% per year stock market gains are behind us for quite a while. We also expect interest rates to start to gradually rise on medium to long-term treasuries and mortgages, though probably not sharply because any sharp increase would set the economy back and likely force more intervention from the Fed. In the next 12-months we expect short-term rates on savings accounts, CDs, and short-term bonds to start to gradually increase as the Fed hikes the Fed Funds rate back to something less extraordinary (we believe 2-3% would still provide support for economic recovery without risking the inflationary dangers of the 0% emergency rate we have today. Finally, we expect a higher level of volatility (up and down) in all financial markets as the Fed-induced tailwind is no longer behind us and now the economy, business cycle, productivity, earnings, and jobs will take more focus.

• The Debt Ceiling – Much is being made of the U.S. debt ceiling and what might happen if it’s not raised and we’re unable to pay our bills. For the most part, this is political grandstanding. There is absolute certainty that the debt ceiling will be raised. But, there’s an important problem in the way Congress is currently dealing with the issue. August 2nd has been set as the “deadline” by the treasury secretary by which the ceiling must be raised in order to proceed with business as usual. For this reason, the credit rating agencies have to consider the possibility that the U.S. will not be able to pay its debts if the ceiling is not raised by that date. Ironically, Congress bashed the credit agencies for maintaining AAA status on collateralized debt obligations that later failed during the peak of the financial crisis, arguing that any risk of default should have caused an immediate downgrade of those instruments way before the crisis occurred. Those same credit rating agencies must now act accordingly and not wait until August 2nd to cut the U.S. rating or they risk having a AAA rating on August 2nd morning and a default rating on August 2nd evening. This means the real deadline to raise the limit is well before August 2nd, because a downgrade of the U.S. credit rating, if taken seriously by the world, will having a snowball effect through the financial markets and set off another deep, albeit temporary, financial crisis. The President’s comment that he will not approve a short-term extension, while obviously in good a faith effort to try to prevent this from being a recurring quarterly problem, actually worsens the situation because it makes the possibility of no deal by August 2nd more likely to the credit agencies. Congress is now playing a game of chicken and I expect a short-term deal is likely with an understanding of more short-term deals through the 2012 elections which will keep the ratings agencies at bay for now. In the meantime though, expect potentially violent moves in the markets, akin to those of the days of TARP being voted on, as momentum traders try to take advantage of the headlines. Since even a credit downgrade would be temporary (garnering a swift response in Congress if it ever did happen), market volatility due to these events is in my opinion, nothing more than an opportunity to rebalance portfolios taking advantage of dips in the market and to get a 401k or other savings contribution in at a cheaper price than without the debt ceiling issue. This issue will pass. The longer-term question of our government’s ability to govern if it’s willing to put us in these kinds of situations to begin with is a much broader issue but I’ll leave that discussion to those who enjoy politics.

• European Sovereign Debt – A less-urgent, but much more important issue to long-term global financial markets is the vast amount of sovereign debt that exists in the world and the sudden realization by financial markets that some countries truly may not be able to pay their bills. This issue is not about an arbitrarily set debt ceiling. Countries like Greece and Ireland are struggling to pay their debts because they’ve taken on so much debt that tax revenues can’t support government spending plus interest payments any longer. These countries, with others like Italy, Portugal, and potentially Spain, not too far behind them, have simply lived on a national credit card for the last decade and are now forced with extreme austerity in return for global bailouts or default. Default means the loans made to those countries become worthless and the banks holding those loans lose the loans as assets. This has the potential to kick off a global financial crisis that is all too familiar after the ‘08/’09 Lehman Brothers default created much of the same. It can also kick off a currency crisis as it threatens the Euro, thereby strengthening the U.S. Dollar and causing harm in our own recovery as it makes our goods, services, and assets seem more expensive to the rest of the world. So far, rescue packages from the International Monetary Fund have staved off default for Ireland & Greece, but this warrants further monitoring. There are three important actions to take here:

· Like others, we have no crystal ball and believe that markets price information and risks fairly in general. That means that in most cases the market would fall before we have reason to believe it would fall or it would rise before we have reason to believe it would rise meaning there is no way to time news events. However, as I’ve discussed with all of you at one point or another, if I hear the whisper of a freight train coming, and sometimes it comes without making a whisper first, I will take corrective action. This means moving all models temporarily to a slightly more conservative allocation or using other protective measures as I see fit.

· It’s easy to be complacent when the stock market is rallying like it has for the better part of the last 28 months. If you have short-term needs for your money that is currently invested as if it was not needed for the short-term, please communicate that need to me ASAP. If your portfolio is 80% stocks and the stock market falls 50%, which has happened twice in the last decade, you will lose ~40% of your portfolio. For long-term money, by definition, you don’t need it over the short-term so that’s not an issue. In that case, continue to invest as planned, buying at lower prices if markets fall and when markets eventually recover you’ll actually be better off than if the fall hadn’t happened. For short-term money though, that kind of a loss could mean not being able to fulfill a goal and goal-fulfillment is the only reason to invest.

· Expect the market to move both up and down. Many have become accustomed to seeing their portfolio balances only increase, and quite sharply quarter after quarter. Don’t be shocked to see more volatility. As long as you’ve heeded the point in the preceding bullet, and you have an overarching financial plan, don’t worry about the short-term movements of the markets. The only ways to ensure that your account statements will only show increases in value are to 1) keep your money in the bank earning slightly more than 0% per year in interest while the cost of living increases far faster, or 2) have a crooked financial advisor that’s cooking the books (and we all know how that ends… google “Bernard Madoff”).

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