Conclusion: Despite fear mongering from the political class about adverse reactions from global markets to a lack of agreement on the debt ceiling in Washington, the U.S. Treasury market is largely shrugging off the drama in Washington. A true default on U.S. debt is highly unlikely in almost any scenario. Further, we believe that a deal will be reached on the debt ceiling and that it will be some derivative of Speaker Boehner’s two-step process.
On Friday, Speaker of the House John Boehner walked away from discussions with the White House over the so called “Grand Bargain” on the deficit. The rationale given by Boehner for walking away from talks with the White House was that President Obama was attempting a last minute tax increase, an issue that Boehner had considered stare decisis. By walking away from discussion with the White House, Boehner has relegated Obama to the sidelines, at least for now.
Following this action by Boehner, the Sunday morning political talk shows were replete with a fear mongering rebuke from administration officials. White House Chief of Staff William Daley called into question the very faith of global investors in the credit of the United States with the following statement on Meet the Press:
“I don’t think there’s any question there’s been enormous damage done to our creditworthiness around the world.”
Daley was only to be one-upped by Treasury Secretary Geithner who said the following on Fox News Sunday:
“We do not have the ability to protect the American people from the consequences of not raising the debt limit. We write 80 million checks a month. There are millions and millions of Americans who depend on those checks coming on time.”
Boehner and the Republicans did not cede ground despite the strong language from administration officials on Sunday morning. As of midday, most global markets are effectively ignoring the political theater in Washington as well. Treasury markets are basically flat today despite the weekend’s collapse in discussions. In the credit default market, swaps are up slightly from Friday’s close, but, as noted in the chart below, still within a normal range.
The market obviously understands, despite attempts at fear mongering by the political set in Washington, that a default on U.S. government debt is unlikely. We could certainly debate whether the U.S. should be rated AAA, or whether ratings agencies should be relevant for that matter, but the actual coverage ratio, as calculated by revenue divided by interest rate, is a very healthy 8.5x for the federal government fiscal year-to-date. The interest payments of the United States have ample coverage.
As the August 2nddate looms, the key outstanding point in the debate appears to be related to duration. The Republicans, led by Speaker Boehner, have proposed a two-step process. Under this process, the debt ceiling would be extended by $2.5 trillion, but in two tranches. The first tranche would be $900 billion and would fund the federal government into early 2012. This tranche would be paired with $1.2 trillion in deficit cuts over ten years, which would be comprised largely of discretionary spending cuts.
The next tranche of $1.6 trillion in debt ceiling extension would be tied to another stage of deficit cuts. These cuts would attack the more difficult entitlement programs like social security, Medicare, and Medicaid. Under Boehner’s plan, a bi-partisan committee of elected representatives would be tasked with finding another $3 trillion in deficit reduction over 10 years (with presumably some credit for a wind down of the wars in Iraq and Afghanistan) and in reporting back by November 1st2011. The next extension of the debt ceiling would be tied to the second round of deficit reduction being passed.
Taken in good faith, Boehner’s proposal is reasonable in that the natural two-part process of cutting spending largely matches his proposal. The first part is comprised of more identifiable discretionary spending cuts, while the second part involves longer term entitlement spending cuts and tax code restructuring. The Gang of Six plan had its day in the proverbial sun last week as a perceived “Grand Bargain”, but the plan’s lack of detail related to entitlement cuts and core tax assumptions made it short lived. The two-part process proposed by Boehner should enable greater detail to be put around the proposed deficit reduction.
The Democrat leadership of President Obama, Senator Reid, and Congresswoman Pelosi are currently united against Boehner’s proposed two-part process. Obama has indicated that he would veto such a proposal. From the Democrat’s perspective, the two-part process extends the debate into 2012, a Presidential election year. In addition, according to Democrat leadership, the extension of the debate would create incremental risk to the U.S. economy and global markets. The chart below of Michigan Consumer Confidence provides some credence to this view as this proxy for broad consumer confidence has declined meaningfully alongside a heightening of the debt ceiling debate.
Given it is just over a week before the August 2nddebt ceiling deadline, it seems unlikely that any unique solutions will be introduced in the coming days. The Democrats in Congress have largely ceded to Republican demands to match debt ceiling increases to spending cuts and to not raise taxes in the traditional sense. As evidenced by the Senate’s 51 – 46 vote against Cut, Cap and Balance late last week, the Democrats have also shown that while they will cede much of this debate to Republicans, much to the chagrin of leftist groups like moveon.org, a balanced budget amendment to the Constitution is a non-starter.
Conversely, the McConnell-Reid plan with a lower level of spending cuts and a proposal to shift the power to raise the debt ceiling up to $2.5 trillion to the President appears to be a non-starter for most Republicans. The McConnell-Reid would limit tax increases, but does not incorporate matching deficit cuts with a commensurate increase in the debt ceiling. The plan does provide Republicans the ability to vote three times on a motion of disapproval related to the $2.5 trillion debt ceiling increase. Not surprisingly, for the Tea Party caucus, a motion of disapproval is clearly unsatisfactory due to its lack of materiality.
It is somewhat ironic that the debt ceiling debate is coming down to a debate over duration given that in almost all proposed plans there is a duration mismatch between increasing the debt ceiling (short term) and implementing spending cuts (long term). Short term fixes for long term issues are typically not sustainable. Europe has provided ample evidence of this on the fiscal front over the last year.
In conclusion, we would expect Boehner and the House to push through a two-part process this week. Interestingly, Senator Thomas Carper (Democrat from Delaware) on CNBC this morning ceded to the idea of a short-term bump up in the debt ceiling and implied that some of his Democrat colleagues would support it. This suggests that a two-part Boehner type process could pass the Senate, even though Cut, Cap and Balance could not garner a majority in the Senate. At that point it would then be up to President Obama to decide whether he would truly veto a bill that has been passed by both Houses. In our view, an Obama veto after a bill passed both Houses is unlikely.
Daryl G. Jones
Director of Research