Debt ceiling déjà vu
 

After a week of political standoff between the Republicans and Democrats, US politicians look increasingly unlikely to meet their 1 October (5pm NZ time) deadline to agree on a US budget.  However, the bigger risk concerning markets is the need for politicians to agree to raise the US debt ceiling by 17 October. 

There are two related political debates occurring in Washington:

1. US budget:  If US politicians fail to agree a new budget by 1 October, non-essential government services will go into a partial shutdown.  The last time this occurred was 1995 during the Clinton administration.  
2. US debt ceiling: The US Treasury Secretary has warned US politicians that, without agreement to raise the debt ceiling, the government will run out of cash by 17 October.  There is also a coupon payment on outstanding debt due on 1 November.  Failure to raise the debt ceiling to meet its funding obligations would effectively trigger a technical default on its debt. 

Republicans have sought to link these two debates by arguing that they will not agree to raise the US debt ceiling unless Obama’s flagship 2010 health insurance program (Obamacare) is repealed in the US budget.   Democrats have held their ground, arguing that, after 40 attempts to repeal the program, Republicans have to accept they won’t always get things their way.

Investors and commentators are feeling a strong sense of déjà vu. Since the Republicans took control of the House of Representatives in 2010, there have been similar debates over raising the debt ceiling in 2011 and 2012, which unnerved markets and rating agencies but ultimately ended in last minute political deals.

While the market expects a last minute resolution to the debt ceiling in 2013, accidents can happen.  So the market must factor-in a small chance of very bad outcome.  Reflecting this, over the past couple of weeks, global equity, currency and fixed interest markets have all experienced some flight to safety from cautious investors.  With a deal to raise the US debt ceiling still not in sight, we expect nerves in market to remain slightly frayed (especially while there are other risks on the horizon, like Italian political uncertainty).

To the extent that US political risk represents pure brinksmanship, once a deal is struck we would expect some of the recent flight to safety to be unwound.

However, to the extent the debate represents a more fundamental message around US fiscal restraint and political dysfunction, investors will need to temper what would otherwise be a positive outlook for the US economy.  With government spending constrained, this puts more onus on the US Fed to retain loose monetary policy until they have a higher degree of confidence that the US economic recovery is on a sustainable path.  It helps justify the no-taper decision in September.        

Ends 

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12:53PM Wednesday, 02 October, 2013