Scenarios for Debt Ceiling Seppuku

Posted on July 28, 2011

Subject(s):

Commerce

As a futurist, I always prefer the long view. But I’m often asked, what are the practical applications of futuring and foresight practice in navigating day to day life, making the sort of fast but high impact decisions that people are often called upon to make? Here’s a good and recent example, Bank of America and Merrill Lynch (ML)* yesterday released a set of “Debt Ceiling Scenarios,” to help guide their clients through the tumults of the next few days as the Republican led U.S. House of Reps and the Obama White house push dueling plans to raise the U.S. debt ceiling by the critical August 2nd deadline. If the U.S. fails to raise the nation’s borrowing limit by that date, and fails to meet its interest payment obligations immediately after, the world’s largest economy will slip into technical default, i.e. bankruptcy. Importantly, in event of default, the U.S. would still have a bit of money to pay down interest on its debt for a few weeks (this is called the prioritization scenario).

What is the likelihood of a default and what would it mean for the global economy? Merrill Lynch attempted to answer both questions.

First, ML continues to hold to the view that a temporary debt ceiling compromise will be reached “in the final hours.” One ML rep I spoke with, who shall for now remain nameless, called the issue am "artificial crisis." In the event that a default does occur, shock waves would quickly reverberate through the broader equities (stocks) currency (FX) and Treasuries and interest rates.

Interest Rates Strategy (Treasury Bonds and Borrowing) (Priya Misra)

In a Treasury default scenario, we expect rates to rise significantly led by the front end of the curve. There are systemic consequences that force deleveraging pressures. Due to the negative economic impact of a prioritization scenario, rates would increase much less, and we would expect the curve to steepen. In the scenarios that the debt ceiling is raised, the critical question will be whether we address the longer term debt sustainability issues. Under most plans under consideration, the longer term debt issues remain unresolved. We therefore expect S&P to downgrade the US to AA and for the curve to continue its steepening trend. We see a small rate sell-off in the near term, but longer term
the safe-haven quality of Treasuries should begin to erode resulting in structurally higher interest rates.

In other words, if the U.S. were to default, Misra expects borrowing from the U.S. government to become much more expensive in the near term (higher rates). That would most certainly hurt the broader U.S. economy as banks borrow from the U.S. government to lend to businesses, and the banks would pass along the higher costs to U.S. borrowers. Importantly, whether the ceiling is raised or not, Misra takes a pessimistic view toward U.S. Treasuries, which Misra expects to decrease in value. In the absence of meaningful reform, which neither party seems able to take on at present, Misra still sees a ratings downgrade from the rating agency S&P as a relatively high likelihood event. This would also increase the costs to borrow and thus would harm the economy.

FX (Currency) Strategy (David Woo)

We cannot overstate the importance of the outcome of the debt ceiling debate for the U.S. dollar’s (USD's) medium-term outlook. The reserve currency status enjoyed by the USD over the past fifty years has always been predicated on the assumption that the US will honor its debt obligations by keeping its fiscal house in order. Given the current size of the funding requirements of the US government, investors need to be assured that the political will is there to deal decisively with the
deterioration of the US fiscal circumstances. Failure to act now could, in our view, accelerate the pace of diversification out of the dollar and reinforce the prevalent fear in the market that the Fed will end up embarking on QE3 as the lender of last resort. In that respect, we believe the USD is likely to weaken if either the Reid plan or the Boehner plan is adopted by Washington to avoid a default. Ironically,
a default is less negative for the USD as such an outcome could increase
demand for safe haven assets.

In other words, in the event of no default, the U.S. dollar would still weaken compared to other currencies. This would help U.S. exporters sell goods cheaper in other countries, but would also make things much more expensive in the U.S. particularly oil.

Stocks, Equity Strategy (Michael Hartnett & David Bianco)

We believe the outcome of the US debt ceiling negotiations will be binary for equity markets: any version of default will have a substantial negative impact on equities while timely solutions will produce relatively muted differences in upward stock market performance.

The worst case scenario where the US defaults and misses an interest
payment would cause a bear-market sell-off in equity markets. We forecast
the S&P 500 would decline to 1050-1150.
In the event that the debt ceiling is not raised by August 2 but interest payments are prioritized preventing an outright default yet significant delays or reductions in other government payments occurs, we believe equity markets will correct with the S&P 500 falling to the 1200-1250 range.

A “best case” scenario where the debt ceiling is raised and at least $4tn worth of cuts offer a reprieve for the US from further ratings downgrades we forecast would take the S&P 500 to 1375. Although this is the "best case" for dollar and rates, equity upside would be limited by a strong dollar and a flatter curve.
We believe the Reid plan would push any further debt negotiation further into the future, removing near-term overhang from the equity market and causing a modest rally to 1400 on the S&P 500.
Like the Reid plan, the Boehner plan would, in our view, be modestly equitypositive and push the S&P 500 to 1400. The Boehner plan is less likely than the Reid plan to include large revenue increases, but is also less likely to raise the debt ceiling as much as the Reid plan.
While we believe the “Gang of Six” scenario is a low probability solution, we forecast the S&P 500 would likely rally to 1425.

So there you have it. In my view, ML’s equity scenarios are far too optimistic, as was the case in 2008. *Full disclosure, I do own assets with Merrill Lynch. I don’t fully trust their advice and don’t recommend or recommend against buying ML. They’re financial planners and are duty bound to push stocks at investors under nearly all circumstances at the expense of the dollar. But, whether you agree with their determinations or not, the scenario exercise does show a brokerage firm attempting to think through uncertainty and pass along foresight communication to stake-holders effectively, which is more than the U.S. House of Representatives is capable of doing today.

About the author
Patrick Tucker is the deputy editor of THE FUTURIST magazine and director of communications for the World Future Society.