The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.
NEW YORK (
) -- Last week, President Obama and Treasury Secretary Geithner reiterated that as of Aug. 2, the United States will have exhausted its ability to borrow under the existing federal debt ceiling of $14.3 trillion. Both sides have failed to craft a deal by the end of June as they had hoped. Moreover, based on public comments made by the President and members of Congress last week, the debt ceiling/deficit negotiations in Washington did not seem to go well.
Senate Majority Leader Harry Reid announced that the Senate will remain in session over this week rather than recess for the holiday to work on the negotiations. Increasingly over the next four weeks, the major issue for the markets will be these negotiations. If a deal is not reached, the
on its obligations or must undertake emergency measures to avoid a default.
We see four potential outcomes with various probabilities emerging from the debt ceiling debate over the next month.
Large Debt Ceiling Increase of $3 Trillion to $4 Trillion:
While we only give this a 20% probability, it could likely be a very favorable scenario for the markets. To achieve $3 trillion to $4 trillion in savings over 10 years, this outcome would likely involve major entitlement reform, substantial tax cuts, and some revenue increases, and would put the United States on a path to fiscal sustainability.
The stock market would likely post a sizable double digit gain over the following weeks with companies in cyclical sectors, such as Consumer Discretionary, potentially winning out over defensive sectors that may bear the brunt of the cuts, such as Health Care. High-quality bonds would also rally although the already low yields would limit overall gains to a few percentage points. The dollar would likely strengthen sharply, leading to declines in commodity prices ranging from gold to oil.
Some may believe 20% is too high a probability that in the next month a historic policy change would take place and that either party would want to address the third rail of politics, entitlement reform, and cast tough votes just six months ahead of the 2012 primary elections. Usually that would be the case.
Indeed, President Obama's 2012 budget avoided the nation's long-term budget problems and actually boosted the deficit. But polls show the political momentum has shifted to the Republicans, and those in the House have proposed a budget that not only addresses the key issues, but proposes big changes including halving Medicare spending by 2021 relative to current law projections. With such a dramatic proposal already on the table and the momentum for change increasing, a historic policy change is not merely plausible, but possible.
Small Debt Ceiling Increase of $1 Trillion to $2 Trillion:
We believe this is the most likely outcome by Aug. 2, with a 60% probability. This outcome contains spending cuts, the closure of a few tax loopholes that raise revenue, and a modest change in the way Social Security benefits are calculated all totaling $1 trillion to $2 trillion over 10 years, but no substantive entitlement reform. This outcome merely "kicks the can down the road" on when the entitlement programs that make up more than 50% of federal spending will need to be addressed until after the 2012 election. The markets have largely priced in this outcome and are unlikely to make a major move in either direction if this is the result.
We place a 60% probability on this outcome because it achieves the near-term objectives of both parties. It appears to make a large dent in federal spending, it defers tough decisions on entitlements and taxes to the next Congress (after the 2012 election when the Republicans may control both houses of Congress), and provides a victory for members of both parties going into the 2012 elections. The GOP will likely be successful in holding out against any significant tax hikes. However, there are some "loopholes" that they may agree to that would raise revenue in the range of $100 billion to $300 billion over 10 years.
Emergency Measures to Avoid Default:
If no deal can be reached, Congress or the Treasury may take emergency steps to prioritize debt payments to avoid default on U.S. debt. Among these steps could be a $100 billion to $300 billion increase in the debt ceiling to give legislators another month or so to craft a deal. This may only be the outcome if the two sides are getting closer as we approach the Aug. 2 deadline.
We peg this at a 20% probability, a sizable uptick after the events of the past week, which saw ongoing negotiations led by Vice President Joe Biden break down. This would be a negative outcome for the markets, but not devastating. With the two sides unable to reach a deal with so much on the line, confidence among investors (and consumers and businesses) would likely plunge. Stocks could pull back 10% or so as the impasse lingers. Treasury yields would rise as bond prices fall on rising fears of default. Precious metals may rise as investors seek a safe-haven alternative to Treasuries.
We saw this happen earlier this year with the 2011 budget. Every few weeks, Congress would pass a new continuing resolution to fund the government for a little longer in exchange for relatively small budget cuts until a more comprehensive deal could be reached. However, this is a more substantial issue, with much more at stake. Any credit for holding to their principles would be overwhelmed by the appearance of an inability to function and would not work in favor of any members of Congress up for election in 2012 as voters look for candidates who claim they can get the job done.
The worst outcome by far. The global financial system seizes up as Treasuries become illiquid. The economy lurches back toward recession. Stocks enter a bear market with a 20% or more decline and Treasury interest rates would soar as bond prices plummet. Gold and other precious metals would likely be beneficiaries of the flight from other assets to a safe haven other than Treasuries.
Even a default of just a week or two would have steep consequences. The United States and the dollar benefit from the vast pools of cash held in dollar-based U.S. Treasuries for their unparalleled liquidity and safety. Even a day or two of default would invalidate this thesis for holding Treasuries by the world's central banks, businesses, and individuals resulting in the permanent loss of Treasuries "risk-free" premium status and perhaps even the dollar's reserve currency status. The rating agencies would immediately move U.S. Treasuries from the highest rating, AAA, to the lowest, D or default.
Finally, even if a deal is hammered out, there are two paths the negotiations could take: a deal by mid-July and a last-minute deal by Aug. 2. By mid-July, the Treasury will likely present the plan for who gets paid in August and who does not. This will be a sobering assessment as federal spending would be cut by a sharp 40% to 45% of the payments it needs to make in August, including $29 billion in interest payments, if the debt ceiling is not raised. If no deal is on track by mid-July, markets could begin to sag as the deadline looms.
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This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.
Jeffrey is Chief Market Strategist and Executive Vice President at LPL Financial.