“The United States has never defaulted on its obligations, and the U. S. dollar and Treasury securities are at the center of the international financial system. A default would be unprecedented and has the potential to be catastrophic: credit markets could freeze, the value of the dollar could plummet, U.S. interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse.
“Political brinksmanship that engendgers even the prospect of a default can be disruptive to financial markets and American businesses and families. The closest historical precedent is the debt ceiling impasse in 2011, around which time consumer and business confidence fell sharply, and financial markets went through stress and job growth slowed. In 2011, U.S. government debt was downgraded, the stock market fell, measures of volatility jumped, and credit risk spreads widened noticeably; these financial market effects persisted for months. To be sure, other forces also played a role, but the uncertainty surrounding whether or not the U.S. government would pay its bills took a toll on the economy. An additional consideration now is the government shutdown that started October 1. If the shutdown is protracted, the economy could be weakened, making the expansion even more susceptible to the adverse effects from a debt ceiling impasse than prior to the shutdown.”
The (ridiculous, embarrassing, shameful) government shutdown and debt ceiling dynamics continue to dominate headlines for now. Markets, ever emotional creatures, will gap up and down accordingly. Similarly sensitive investors will subsequently chase markets in both directions. For our part, we are keeping our eye on the finish line. Don’t lose site of the fact that a deal will get done. The consequences of the alternative are simply TOO DIRE, as highlighted by our opening quote, an excerpt from a recent report by The U.S. Treasury.
The risk of a default is low. We recognize it is greater than zero. We estimate that market sentiment is still too optimistic, given the small chance that one party or another miscalculates during the debate illustrated below. While we are sure a deal will get done, the timing of any announcement is obviously the biggest question and greatest risk for markets. Consequently, investors can capitalize on brinkmanship by focusing on intrinsic value rather than political noise and putting cash to work when the spread between the two blows out, compliments of our friends on Sesame Street. See also Word of the Day.