Wall Street and Washington are in a game of chicken. Will it end with a splat?

September 25, 2013

There's a strange game of chicken underway between the financial world and the lawmakers who collectively set U.S. fiscal policy. And there are big risks ahead that it will end badly.

Washington is gearing up for yet another of its semi-regular adventures in fiscal brinksmanship, for something like the fifth time in three years (depending on exactly how you count). To people immersed in the policy world, this seems like it could be the big one, on par with, or worse than, the confidence-rattling July 2011 standoff over raising the debt ceiling. Here's Ezra Klein explaining why.

This year feels different from the fiscal cliff standoff at the end of 2012, when Congressional Republicans were clear that they wanted a deal, the contours of the negotiation were plain to see, and the consequences of no deal would have been an economic downturn rather than a global financial panic. None of those things apply this time. House Republicans are demanding that President Obama effectively abandon his signature health reform law in exchange for a deal; if the president were to acquiesce, it would make him the worst negotiator in history. And while the U.S. economy could likely take a temporary government shutdown in stride, a breach of the debt ceiling would almost certainly bring on a burst of volatility in financial markets and damage consumer and business confidence.

So that's the view from Washington. Here's the view from Wall Street, in one chart:


That is the Vix. It is a measure of how much volatility traders expect there to be over the 30 days to come. When the world looks scary -- when it looks like there will be a lot of wild ups and downs in the market over the coming weeks -- the Vix spikes. As the chart shows, though, there isn't even a hint of worry about U.S. fiscal policy showing up in the Vix right now. Indeed, it was way higher as recently as June, when the Federal Reserve said it would soon begin slowing down its bond purchases.

There are some other indicators where you can see hints of worry creeping into markets, as in this chart that my colleague Jim Tankersley posted Tuesday showing a spike in prices for credit default swaps on U.S. government debt. (It's essentially the price of insurance against a U.S. government bond default, meaning that the higher the number, the more risky the U.S. government is as a borrower).

Source: Markit
Source: Markit

This is indeed a sign markets are starting to worry about the debt ceiling, but not a sign that they are freaking out in any big way. Note that the new price of CDS is still below where it was as recently as early May. And this is a bit of a curious measure; first, even if the U.S. government breaches the legal debt ceiling on or around Oct. 17, it would almost certainly prioritize repaying bondholders against other obligations, such as paying government contractors, employees or Social Security recipients.

So, Wall Street isn't really sweating this. Washington is the boy who cried wolf; with the fiscal cliff, the supercommittee negotiations of late 2011, and the debt ceiling negotiations of July 2011, there was a lot of drama, a lot of brinksmanship, but then, ultimately a deal. If you're a big hedge fund, it increasingly looks like a loser's bet to put big money at stake on the possibility that we'll get July 2011-style stock market volatility, or a default on U.S. Treasury bonds.

Somebody is wrong. Either the Washington consensus is totally misreading the resiliency of our political system and the ability of our leaders to, when their backs are against a wall, do what they must to keep the government operating and its bills paid. Or investors are the naive ones, failing to understand the many ways that October 2013 is different from, say, December 2012.

The greatest irony is that the thing that would most force attention among Washington policymakers toward the job they need to do would be a bout of market volatility. The dramatic zigs and zags of global markets in late July 2011 created a sense of urgency around that debt ceiling deal. The bank bailout legislation in 2008 passed the House only after a 700-point drop in the Dow that followed an initial rejection. There's nothing like seeing Americans' 401k accounts plummet to focus the mind of even the most reluctant member of Congress.

So the real question for Washington over the next few weeks is not whether there will be a deal. There will be a deal, because there must be a deal. The question is how much drama will need to come from Wall Street to help bring one; at the same time, Wall Street doesn't want to lose money by betting on a crisis that never arrives.

The great risk is that this is a game of chicken that ends with a splat.

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Dylan Matthews · September 25, 2013