It’s starting to get real. In four days, the U.S. government is poised to shut down. In three weeks, the U.S. Treasury is poised to run out of its legal authority to issue debt. Fiscalmageddon may soon be upon us. And Wall Street, having been remarkably complacent about the doings in Washington—or lack thereof—is starting to get concerned.
The prospect of a government shutdown next week, and the unprecedented default on U.S. debt in 20 days, should have crystallized the minds of traders. But in the age of high-frequency trading and 24-hour markets, investors have attention spans that make millennials seem like pictures of patience. Now, however, on the trading floors in Stamford and Manhattan, in the conference rooms of hedge funds in Greenwich and on Park Avenue, portfolio managers are starting to fret. Less focus on portfolio, more focus on Politico.
In the last few days, investors have opened the Washington Brinkmanship Playbook. Washington crises create uncertainty and tend to slow economic growth. The way you position yourself for this is to sell stocks, and, paradoxically, to buy government bonds. That has happened this week. Stocks are down four of this week’s five trading days. The chart of the Standard & Poor’s 500 below shows a general downward drift over the past couple months. In the past five days, the yield on the 10-year bond has fallen from 2.72 to 2.62 percent.
These are relatively gentle declines. And the conventional wisdom seems to be forming. It’s possible, even likely, that we’ll have a brief government shutdown next week. That would be, in the minds of many on Wall Street, a small, almost non-event. I’ve spoken to several professional investors, all of whom believe a shutdown, should it come, would last at most a day or two. That would be problematic—it might mean, for example, that the Friday jobs report doesn’t come out. But it wouldn’t fundamentally alter the trajectory of the U.S. or global economy. In terms Wall Streeters can understand, it would be like your Porsche getting a flat tire.
Indeed, the conventional wisdom seems to be crystallizing that it would be a good thing. Why? Having thrown a tantrum and shut down the government, Republicans would then move on to the business of governing and work to avoid a debt ceiling crisis, which would be far more serious. In a research note, Goldman Sachs analyst Alec Phillips argued that Republicans in Congress wouldn’t have an appetite for two successive debacles. “The upshot is that while a shutdown would be unnecessarily disruptive, it might actually ease passage of a debt limit increase,” he wrote. Over at Bloomberg, Joshua Green makes a variation of this argument. Then, somehow, this line of reasoning goes, the debt ceiling will be resolved without a real default. Of course, Wall Street analysts don’t have any fix on what a path to that outcome looks like, any more than House Speaker John Boehner does. They just can’t see any other acceptable alternative. Everybody—foreign central banks, foreign banks and insurance companies, investors, and companies—owns government bonds. If the value of those assets were to be called into question—through a partial default, or a delay in payment, or the suspicion of a hint or a whiff of a default—unimaginable chaos would ensue. In terms Wall Streeters can understand, it would be like your Porsche smashing into a brick wall at 100 miles per hour.
But some people on Wall Street have been paying attention to the news and understand that this crop of Republicans in the House is problematic and potentially dangerous. “There’s some concern over the debt ceiling and how far they’re going to push it this time,” a bond trader told me.
Some people on Wall Street have been paying attention to the news and understand that this crop of Republicans in the House is problematic and potentially dangerous.
Now, if a company were threatening to default, if a bunch of its managers openly mused about whether it was necessary for the company to pay all its bills in a timely manner, you’d expect investors to dump the company’s bonds with alacrity. With governments and government entities, the dynamic is usually a little different. Many of the biggest owners of U.S. government bonds—China’s central bank, Japan’s central bank, the Federal Reserve, every large U.S. bank—can’t really dump their holdings without further reducing the value of the rest of their holdings. They’re pretty much all-in on the creditworthiness of the U.S. government. You can’t really position a giant portfolio to account for a default.
But if your positions are smaller, and if you’re the gambling type, you can position your portfolio to try to profit, or protect yourself, from some temporary instability. And we’re seeing that in happen in a few places. Gold, a hedge against chaos of all sorts, which has been falling in value recently, is up about 1 percent Friday. The dollar, a proxy for confidence in all things American, has been taking it on the chin against the euro and is now trading at $1.35 per euro. This as the U.S. is growing more rapidly than Europe, as Greece is seeking a “debt reprofiling,” and as Italy is fending off rumors of a downgrade.
We’re also seeing heightened concern of political risk expressed in the market for credit default swaps (CDS) on U.S. debt. CDS are basically insurance policies investors take out against default. You pay a few cents on the dollar, and if a company that has issued bonds defaults or goes bankrupt, you get paid off at $1.00. Investors trade credit default swaps on companies, but also on sovereign debt issuers, like the U.S. It’s a very small market. “The cost of insuring against a U.S. default for a year has risen sixfold in the past week, reaching its highest level since 2011,” Katy Burne and Damian Paletta reported in The Wall Street Journal on Friday. To buy protection on $10 million in U.S. government debt for a year costs 31,000 euros, up from about 5,000 euros a week ago. (As Burne and Paletta note: “default protection in U.S. Treasuries is quoted in euros, just as European sovereign CDS contracts are quoted in dollars.” That price is still a fraction of the asset being insured, which means investors aren’t really that worried about a default.
Give it a few more days.