Markets bet against debt default

  • Article by: JIM SPENCER , Star Tribune
  • Updated: July 13, 2011 - 2:27 PM

There's no sign of a "default dip" ahead of the debt ceiling deadline -- so far.

WASHINGTON - The scenario is nothing short of apocalyptic: If the U.S. doesn't raise its debt ceiling so it can borrow more, the U.S. will default on loan payments for the first time in its history. The stock market will tank. Jobs will be lost. The country will plunge back into recession.

It is nearly impossible to find an economist or investment adviser who disputes the doomsday of a national default. But as the Aug. 2 deadline looms to adjust the debt ceiling and Congress remains gridlocked on a solution, it is equally difficult to find signs of impending economic Armageddon in the stock market.

In recent months the markets have, at times, retreated over the debt troubles in Greece, high oil prices, even the negative jobs report on Friday. And yet, there has been little upheaval over the debt ceiling deadline.

"The market is saying [default] would be so problematic that it's a chip that can't be played," said Harrison Grodnick, who with his father, Phil, runs the Minneapolis Portfolio Management Group. Allowing the country to default is "a self-inflicted wound that is somewhat insane," he added.

So insane that Wall Street investors seem to be banking on a political compromise.

In fact, the markets remain bullish overall. The Dow Jones industrial average is up almost 10 percent year-to-date. In Minnesota, stocks for major companies have held strong, as the Star Tribune Top 100 has surged over 10 percent since the start of the year -- no sign yet of a "default dip."

At the same time, financial advisers in Minnesota and across the country have been quietly repositioning their clients' portfolios, selling long-term bonds, including U.S. Treasury bonds, and adding cash to accounts just in case. As time runs out, playing chicken with the debt ceiling portends unsettling volatility in the stock market, not unlike the wild swings that accompanied the subprime lending scandal, investment analysts say.

"The Tea Party may want to do some more grandstanding," said Brian Jacobsen, the chief portfolio strategist at Wells Fargo Funds Management. "If this debate drags on into September, it could be a significant drag on the U.S. economy." In such a scenario, Jacobsen predicts that investors would sell off U.S. stocks in market-wrecking volume as they "duck and cover and go to cash."

Bill Stevens, the founder of Bloomington-based Stevens Foster Financial Advisors, handles investments of wealthy corporate executives. Stevens expects Congress to settle on a way to avoid a government default but is prepared to make preemptive moves if a deal appears unlikely. "If we're two days before the deadline and we've got name calling, we might move more [client funds] to cash," Stevens said.

At Minneapolis Portfolio Management, the Grodnicks are looking for "good businesses with good balance sheets" that they can pick up cheap during "panicky volatility" if Congress carries on its acrimonious and histrionic debt ceiling debate.

But no one seems to believe the politicians in Washington will let the government default. Missing interest payments on government-issued bonds will almost certainly increase interest rates the U.S. must pay on future government-issued bonds. Economists say a single percentage point rise in those interest rates would add more than $1 trillion to the national debt, which would only compound the deficit issues Congress is trying to address.

"Hopefully, rational people will make rational decisions," said Russell Price, a senior economist for Minneapolis-based Ameriprise Financial Services Inc.

One of the first signs that Wall Street thinks that won't happen will be increased premium rates for credit default swaps, a kind of insurance that covers U.S. government debt, said V.V. Chari, an economist for the Minneapolis office of the Federal Reserve. For now, those premium prices remain "exceptionally low," Chari said.

Looking ahead, credit agencies could downgrade U.S. bond ratings. In April, a warning that this could happen led to the single largest daily sell-off of stocks in a month. Since then, the market has recovered. But talk of downgrades will start again in late July without a debt ceiling resolution, many experts agree.

"The risk grows significantly as we come closer to the deadline," Price said. Downgrades "would be a bad day for the market in general."

Yet the political posturing shows few signs of letting up. President Obama tried to break the deadlock late last week pairing a proposal to raise the debt ceiling with a separate, but parallel program to cut $3 trillion to $4 trillion in spending from the national budget over the next decade. Republicans bemoaned the end of tax breaks for wealthy Americans and corporations. Democrats balked at cuts to Social Security and Medicare. Meetings continued through the weekend, but both parties stressed that they were "far apart."

"You've got so much polarization [in Washington], and it's not just tied to the economy; it's tied to social agendas," Stevens, the Bloomington-based financial adviser, said. "They're fighting the Crusades again. Financial markets don't like that."

Many financial experts agreed that the necessary debt ceiling increase will not work without a concurrent program of spending cuts and revenue increases. Most said reform would have to include Social Security and Medicare.

Without deficit reduction, said Ameriprise's Price, "we're headed toward a debt to [gross national product] ratio that economists typically think is not sustainable."

Independent investment adviser Rebecca Hall trained as an economist and trades through Ameriprise. As a resident of a Washington suburb, she has a close-up view of the debt ceiling debate. In anticipation of the political brinkmanship, as well as the end of the Federal Reserve investment in government bonds, Hall has spent months decreasing her clients' holding in long-term bonds and increasing the amounts of cash in their accounts.

Still, she says, there's no way to protect everyone from the calamity of a U.S. default, so she hopes a deal is reached. "At the end of the day, we have to come to terms with the reality of raising the debt ceiling."

Staff writer Patrick Kennedy contributed to this report. Jim Spencer • 202-408-2752

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