Washington remains shut down for a second week as rival groups in Congress cannot agree on authorizing spending to continue funding the U.S. government. The sticking point is “Obamacare,” the President’s hallmark health care program which is strenuously opposed by parts of the Republican Party that have demanded a cancellation of the program as the price for passing a spending bill. With both sides not willing to compromise, the federal government has been shut since the new fiscal year began on October 1.
On top of the shutdown of the nation’s capital, the government is approaching another limit - - the $16.7 trillion ceiling for total debt, beyond which additional borrowing requires Congressional approval. It is estimated that this maximum borrowing limit will be reached on, or about, October 17. Again, with the Republican opposition not willing to authorize a hike in the debt limit, the United States, the largest and richest economy in the world, runs the risk of defaulting on its obligations before the end of the month.
What would a default mean? It has been compared with a depositor finding out that a bank has run out of money and the ATM does not provide cash, even though the depositor has funds in the account.
Similarly, lacking legal authority to borrow additional amounts, the U.S. Treasury could be forced not to make interest payments on debt, stop paychecks to government workers, or delay social security payments. While some analysts have suggested that the Obama administration prioritize interest payments on debt in order to avoid a potential rating downgrade, it is not clear that authorities have the operational capability to change the payment sequence. What is more, it may not be legal either, to decide to delay sending out social security checks, for example, in order to use the resources to pay off maturing US Treasury bills.
The result of all this has been massive uncertainty in the financial community about the US credit standing in the short-term. This week, a large US mutual fund company is believed to have sold all its holdings of Treasury paper maturing during the rest of October. Even though there is every expectation that the short-term debt will eventually be repaid, creditors fear a loss of liquidity, i.e., they may not be paid on time. In turn, this has implications for other financial assets based on US Treasury obligations. For instance, there is concern that money-market funds backed by Treasury bills may not be redeemable on time. And since many households use money market funds almost as substitutes for insured bank deposits, this concern has added to the overall nervousness.
The new risk that the US may not make timely payments on short-term debt has resulted in those obligations surging in yield. For example, in the chart below, the dotted yellow line shows the US Treasury yield curve on September 10. Note that the one-month bill yielded only 0.01% (lower left portion of the chart) a month ago. By October 10, that yield had surged to 0.25% (solid green line), reflecting the increased uncertainty that the bill may not be paid on time. Notice, as well, that in the case of Treasurys maturing in a year (right side of the chart), the yield is currently lower than it was a month ago. In other words, the market is implying that there is a short-term risk. Since this also implies a new global risk, investors are seeking protection by investing in longer term Treasury obligations as a safe haven.
Market turbulence is not confined to domestic financial markets. China, the largest foreign holder of US Treasurys - - with about $1.5 trillion of the $3.5 trillion in Chinese foreign exchange reserves held in US obligations - - has had several foreign officials warn the United States not to default on its obligations. In the annual meeting of the International Monetary Fund taking place this week in Washington, the major topic of discussion was not the global economic outlook but implications of a potential US default for the rest of the world. And President Obama was forced by Washington developments to cancel a trip to Asia last weekend to attend a major summit with Asian powers. This allowed China to serve as the dominant power at the Asian summit.
Washington developments remain an ongoing story. A suggestion from Speaker John Boehner on October 10 that he would be prepared to allow a temporary increase in the debt limit in exchange for new negotiations caused US equities to surge after several days of decline. However, even a six-week delay in implementing the debt ceiling will only provide the government - - and financial markets - - a temporary reprieve. Those who follow the financial market should not exhale yet!