Globally, the shadow of the 2007-2009 Financial Crisis continues to color the behavior of financial markets. Unemployment remains high in the United States, and very high in many southern European Union countries: Greece, Spain, Portugal and Italy. Economic growth remains slow. While bank balance sheets have become stronger in the US, there are still concerns in Europe, with uncertainty about Spanish banks in particular. In general, this pattern is consistent with the observation (made in This Time is Different) that recoveries from recessions associated with financial crises tend to take longer than do recoveries from business cycle related recessions.
The US Federal Reserve Bank (the Fed) continues its large purchases of mortgage-backed and US Treasury bonds (popularly known as Quantitative Easing III or QE3 for short). By providing extra demand, the Fed hopes to keep the prices of these bonds higher, and their effective interest rates lower, than they would be otherwise. Since June 19th, when Fed Chairman Ben Bernanke indicated in his news conference that improving economic conditions might lead to the Fed reducing these purchases, investors have begun to speculate about when such “tapering” might occur. If Fed purchases are keeping interest rates low and bond prices high, fewer purchases would allow interest rates to rise as bond prices fall. Investors have anticipated this effect: bond prices have fallen and interest rates have risen since Bernanke’s remarks.
The Fed is referring to a variety of improving economic conditions. The economy continues to grow and add jobs. The unemployment rate continues to fall. Housing prices have risen, and housing starts have recovered somewhat since the Great Recession trough.
Unfortunately, major political factors are muddying the water. The Congress is caught up in two significant disagreements:
- There is no budget for the Federal government. Congress must pass a budget for fiscal 2014, and the President must sign it. Congress has been unable to agree on a budget. The current disagreement is about a “Continuing Resolution,” which simply extends last year’s budget for six weeks in the hope that the extra time will allow an agreement to emerge. Unfortunately, the Republican-controlled House of Representatives has linked defunding and/or delay of ObamaCare (the Affordable Care Act) to the Continuing Resolution, and the Democrat-controlled Senate refuses to countenance any such linkage. By the way, the Continuing Resolution continues the “Sequester,” a set of spending reductions in place since last March that neither party claims to like, but for which no credible alternative has emerged. At this writing, the impasse is unresolved.
- The Federal debt is about to breach the debt ceiling. Until the very recent past, Congress has perfunctorily increased the ceiling to prevent a breach. Republicans have recently identified the ceiling as another point of leverage, and apparently plan to link delaying or defunding ObamaCare to this item as well.
As of this writing, no budget has emerged, and the government has been forced to “shut down,” or more accurately, curtail certain operations. The military will continue to function, as will the Post Office, air traffic control and other essential departments. This will have relatively small impact on the economy overall, but significant impact in geographic areas where the Federal government is a major employer.
If the Congress does not raise the Federal debt limit, the Treasury will be forced to decide which payments not to make. Tax receipts are smaller than (roughly two thirds of) payment obligations, so the omitted payments will be large. The Treasury could choose not to pay government contractors, or Social Security recipients, or Federal employees (like military staff), or, conceivably, interest and principal payments. While any of these omissions would have significant impact on the economy, failing to make payments on Treasury bonds would likely be the most significant. This would be a failure of the “full faith and credit of the United States,” and could cause enormous turmoil on global financial markets. At this relatively early date, it is entirely unclear which payments the Treasury would omit if the debt ceiling is not raised.
As was the case in previous major budget and spending disputes we have seen between and among the President, House and Senate, securities markets are likely to fluctuate amid the uncertainty. The dispute about the debt limit, with its much larger potential consequences for the US and world economies, is likely to produce more investor uncertainty and more market choppiness.