We need to preface this by stressing that we are politically neutral, that our views below are non-partisan and strictly based on the weight of evidence seen thus far.
An endemic risk that the market has been ignoring for a while but which is starting to gain traction has been the need for the US Congress to pass legislation on lifting the debt ceiling (currently at $19.8 trln).
Why it's even more important now?
As an aside, we need to answer the question of why lifting the debt ceiling is now more important to the US and to the market.
- It all boils down to weaker than expected tax collections that has led to a much larger budget deficit for 2017, and with Trump doubling down on military spending (new defence bill decimates the budget caps imposed in 2011) and contradicting his pledge to return the US federal budget to a surplus by 2025.
- Even more so considering his other proposals include a $200 bln infrastructure program and a tax cut.
At this stage, there's been contradictory signals out of the White House administration.
- Treasury Sec Mnuchin wants a "clean" bill that unconditionally increases the debt limit, while budget chief Mulvaney and the GOP rightwing (Freedom Caucus) supports attaching conditional riders (ie spending cuts or policy priorities).
The issue here is that the debt limit was bumped up against in Mar, and the US Treasury has been using "extraordinary measures" to fund the govt since then although the limit of these measures are set to be breached in early to mid-Oct given weaker than expected tax collections.
Last Fri, the US Treasury issued a dateline of 29 Sep for Congress to lift the debt ceiling failing which a govt shutdown and subsequently a disorderly default becomes the inherent risks.
Risks and implications
A US default seems unlikely, given the previous debt ceiling standoffs in 2011 and 2013 both did not disintegrate into a default.
The risk of a govt shutdown and the market taking it badly is however much more real.
As a backdrop, the Trump administration's failure to push through any significant legislation doesn't give us confidence that they can provide leadership on this.
Even more significantly, there's the deep divisions within the GOP itself that prevents them from governing, even though they have a trifecta control over both factions of Congress and the White House.
- Case in point being how the Freedom Caucus has continued to attach tough demands on spending cuts and the 2018 budget as a whole in exchange for lifting the debt ceiling, something that they have done since President Obama's time in office.
- Again, this will be met with stiff and unanimous opposition from the Democrats (much like in Obama's tenure) which highlights the risk of a deadlock panning out.
Even more damning is the indications from President Trump that it may be "good" to have a govt shutdown to force action, which is a perverse line of thought given it could lead things down the path of no return and irreparable damage (in terms of the US image).
Last but not least, we need to consider how this could impact on the Fed's tightening plans and more importantly, it's plans to unwind their balance sheet.
If we see a market convulsion owing to a US govt shutdown and a potential default, there would appear no chance of them starting the balance sheet unwind in either Sep or Nov, or to deliver a 3rd hike for 2017, given their traditional allergy to market volatility.
Likely market reaction
The underlying view here is that while there is a real threat of a disorderly govt shutdown, the US isn't going to default.
In this scenario, we will see the market rotate even more out of s/t T-bills (which they have already started to do) and into long-term debt, resulting in a flattening of the yield curve.
The broader market implication though could be heightened volatility, a possible return of risk aversion that weighs down on risk assets that helps to prop up the USD. JH