The markets are starting to react. One of the most intriguing news stories during the first week of the government’s shutdown was that the stock markets remained relatively stable and didn’t seem to react too negatively to the shutdown. During that first week, the NASDAQ fell by eleven points or approximately 0.3% and the Dow Jones Industrial Average fell by 81 points, or roughly half of a percentage point. Since the markets opened today, however, the NASDAQ has fallen by two percent and the DJIA has fallen by over a percent. This sudden drop has many asking why did markets wait a week before reacting? What news about the shutdown came out of the White House or Congress today that caused the markets to finally take notice?
To answer this, it’s possible to analyze how the shutdown has affected business, how long market analysts expect it to last, and other similar indicators. Or, you can accept a different answer altogether – the markets are reacting to something other than the government shutdown. This seems to be exactly the case. In particular, it seems quite plausible that these market movements are reflective of the previously discredited possibility that the United States may actually hit the debt ceiling. One indicator that it’s the debt ceiling debacle rather than the ongoing shutdown woes that has the markets on edge is today’s development in the Treasury bond markets. Last week I predicted that “even if a default doesn’t occur, the threat of a default could cause the interest rate on [treasury bonds] to skyrocket.” That’s exactly what seems to be happening as today’s stock market volatility was dwarfed by the volatility in the Treasury bond market. Interest rates on U.S. Treasury bonds which are set to mature on October 17th, the day the Treasury is expected to have exhausted all available “extraordinary measures” have doubled today and increased ten-fold since Sept. 30th. This closely mirrors what happened in the run up to the August 2011 debt ceiling crisis when interest rates on repurchase agreements, which primarily consist of Treasury bonds, rose from 2 basis points (0.02%) all the way to 28 basis points (0.28%). The interest rate on short term Treasury bonds increased from 3 basis points (0.03%) on Sept. 30th to 16 basis points (0.16%) yesterday before more than doubling to .360% today (increasing by an entire 6 basis points since I started writing this article). This rate, which is also known as the yield rate for one-month Treasury bills, is the highest it has been since 2008.
Why are interest rates rising?
What caused the markets to react much more strongly today than in the past week? After all, both Boehner and Obama have been pretty steadfast in maintaining their positions over the past week with Obama continuing to claim that he will not negotiate over the debt ceiling and Boehner maintaining that he is neither willing nor able to allow a “clean” debt ceiling bill to pass the House. With both sides holding their ground and thus not doing much to change the calculus relating to whether or not the U.S. will default on its debt, it’s possible that the reason for the markets jitters today were caused by something other than Mr. Boehner or Mr. Obama’s actions. Instead, it would seem as this volatility was precipitated by statements made yesterday by Senators Burr (R-NC), Blunt (R-MO), and others. Senator Burr argued that:
“The federal government still has about 85 percent of the revenues we spend coming in, and all they have to do is prioritize that they’re going to pay debt service first. And that leaves some prioritization for federal programs. I’m not as concerned as the president is on the debt ceiling, because the only people buying our bonds right now is the Federal Reserve. So it’s like scaring ourselves.”
The problem with this argument is that it simply isn’t factual. Incoming revenue varies from day to day and would only allow the Treasury to pay 65% – 75% of the payments which also vary by day. Additionally, while the Federal Reserve’s attempts to keep interest rates low have required them to buy a significant number of Treasury bonds, it’s far from true that they’re the only ones purchasing our debt right now. Here’s the actual breakdown of who holds our debt (these figures are similar, but not perfectly aligned with who is currently purchasing Treasury bonds):
- Foreign governments – $5.590 trillion
- The Federal Reserve – $2.07 trillion
- State and local governments – $709 billion (much of it in pension funds)
- Mutual funds – $805 billion
- Private pension funds – $605 billion
- Banks – $305.2 billion
- Insurance Companies – $259.1 billion
- U.S. Savings Bonds – $184.7 billion
- Others – $1.14 trillion
Later in the day, Senator Blunt claimed that:
“The credit rating went down, according to Standard and Poor’s, as I recall it, because Congress wasn’t doing anything to get the spending under control. It had nothing to do with the debt ceiling. … Of course, you pay the interest on the debt. It’s part of the debt obligation. Prioritize the order in which you pay your bills? That’s no definition of default I’ve ever heard used in any way. Default is when you don’t pay your loan. Prioritizing how you pay your bills is prioritizing how you pay your bills.”
Again, this isn’t exactly true. The actual S&P report explaining why our credit was downgraded from AAA to AA+ included multiple reasons, one of which was Congress’s inability to raise revenue and reduce spending enough to reduce the debt burden. However, the very first sentence in the S&P’s rationale cited “the prolonged controversy over raising the statutory debt ceiling”.
The biggest problem with these statements isn’t their nearly complete lack of factual accuracy, instead it’s the sentiment they represent. As David Weigel explains, a growing number of House Republicans (who are now being joined by Senate Republicans) genuinely believe that the United States can default on our debt without facing massive repercussions. The logical extension of this belief is that it may make sense for House Republicans to allow the United States to default on their debt in the very same way that it was logical for them to allow the government to shut down. This would directly challenge Speaker Boehner’s longstanding assertion that he will not allow the United States to default which by and large was what the markets believed.
This group of lawmakers that disagree with the common wisdom about how severe a debt ceiling breach would be are joined by a group of Congress members who disagree with how the markets would react to a default. In an interview yesterday, Sen. Hatch (R-UH) told reporters that “I think the administration could work on who gets paid and who doesn’t in a way that would pull us through.” before continuing with “I don’t think the markets have been spooked so far”. Sen. Hatch is joined by Rep. Ted Yoho (R-TX) who argued that breaching the debt ceiling “would bring stability to the world markets,’ since they would be assured that the United States had moved decisively to curb its debt.”
Who’s right: The markets or the GOP?
Where does the dichotomy between what the markets believe and what House and Senate Republicans believe come from? The answer lies in their different perceptions of how capable and effective President Obama and the Treasury Department are. And here’s the kicker – Republicans are placing more trust in the Treasury than businesses are. As Weigel notes, many House and Senate Republicans fully believe in the ability of the Treasury to prioritize debt payments so that our debt is still serviced and military and entitlement programs are paid for. As Rep Joe Barton (R-TX) explained on CNBC earlier in the week “We’ve got more than enough cash flow, more than enough cash flow to pay interest on the public debt when it comes due … And I would assume as smart as President Obama is, when push comes to shove, he’ll be smart. So we are not going to default on the public debt. But that doesn’t mean that we have to pay every bill the day it comes in”. Here’s the issue – we may have to pay every bill the day it comes in.
As I noted last week, FedWire, the settlement funds stransfer system used to make sovereign debt payments isn’t set up in such a way as to prioritize certain payments. The same is true for the Financial Management Service which uses the Automated Clearing House to make payments to vendors and agencies. The Treasury’s Inspector General has stated that both FedWire and FMS are currently programmed to make payments in the order they’re received and changing that isn’t something which is easy to do. Mark Patterson, a former Chief of Staff at the Treasury explains that “[Treasury payments] involve multiple agencies. It involves multiple interacting computer systems. And all of them are designed for only one thing: To pay all bills on time. The technological challenge of trying to adapt that to some other system would be very daunting, and I suspect that if we were forced into a mode like that the results would be riddled with all kinds of errors.” But hey, this might be a great time for a skilled computer programmer to apply to work for the Treasury – I’d be willing to bet that preventing economic collapse would be enough to keep you from getting deemed “non-essential.”
The second aspect of debt prioritization would be difficult for the Treasury is the legal aspect. Numerous journalists, analysts and government officials have all commented on the lack of legal precedent for debt prioritization. Most notable is the Treasury’s stance which is that it lacks the legal, as well as functional, capabilities to prioritize debt payments. This issue isn’t one as complicated as the technical side of prioritization, however. As the Congressional Research Service explains in a September report to members of Congress, in 1985 the GAO wrote to then-Senate Finance Committee Chairman Bob Packwood that “The Treasury is free to liquidate obligations in any order it finds will best serve the interests of the United States”. No statutory limitations on the order in which the Treasury pays its debts have come to be since this time and thus and argument can be made that this is still the case. Furthermore, it is still possible that were a default to become imminent (or actually happen) Senate Democrats would join House Republicans in passing legislation granting the Treasury the legal authority to prioritize debt payments.
Whether you choose to believe Secretary Lew and the Treasury’s stance concerning the impracticability of prioritization or instead believe that the Treasury’s claims are simply a tactic which President Obama is utilizing in order to place additional pressure on Congress, only one thing is entirely clear: debt prioritization is uncharted waters and no one knows what exactly will happen if we have to utilize it.
If these developments don’t worry you, they should. This increase in interest rates, if it lasts, will have a compounded effect on the Treasury department. Not only will it make the Treasury’s even more strapped for cash, but by increasing the cost of servicing our debt (which already cost $223 billion in 2012), higher interest rates will force the government to spend even more on debt servicing. The $29 billion debt interest payment which comes due on Nov. 15th, could be rather small to the interest payments we would have to make in the future.
As Brad Plummer notes in the Washington Post, the economic consequences of an actual default would be even more severe than what is happening as markets prepare for the possibility of a default. He points out that an inadvertent default in 1979 which caused the United States to default on $122 million worth of Treasury bills, increased borrowing costs by 6% or $12 billion dollars. In what seems like a recurring theme, the impact of an intentional default on an amount of debt that is of an entirely different order of magnitude is impossible to predict and frightening to think about.
The last remaining unknown (a known unknown as Donald Rumsfield would call it) is what would happen if prioritization were successful. As far as we can tell, it wouldn’t be a pretty scene. Even if prioritization works well enough to allow our debt to be properly serviced, the impact of missed bills elsewhere could be as large as 4.2% of annualized GDP. A report by Deutsche Bank concluded that a scenario in which the United States hits the debt ceiling, but manages to prioritize payments so that a resolution is reached before any interest payments are missed could result in the S&P 500 falling by as much as 10%. That same report concluded that if the United States did end up missing an interest payment (the first major one would come due on Oct. 31st and an even larger one would follow fifteen days later), the S&P 500 would lose as much as 45% of its value. For comparison, that’s roughly equivalent to the decrease in the value of the S&P 500 between October 2007 and May 2009.
So there you have it. After a week of relative stability, the global financial markets finally began to react to the dysfunction in Washington. With the debt ceiling set to be hit in little over a week, this sort of economic uncertainty and volatility is only likely to increase in the upcoming days. Only time will tell what can happen if an agreement isn’t reached to raise the debt ceiling. We are a nation on the edge and this game of brinksmanship may forever change what the full faith and credit of the United States represents. That would be a shame.