Markets (still) aren’t too worried about the debt ceiling. Markets are sometimes wrong.

October 4, 2013

In communications out of the Obama administration lately, you almost detect a sense of frustration. Not just with Congressional Republicans. There's also frustration with financial markets, which aren't reacting with the kind of hyperventilation one might expect when a default by the U.S. government is being discussed as a plausible outcome of another debt ceiling stand-off.

Here, for example, is the Vix, a measure of expected stock market volatility. It is indeed up a good bit in the last two weeks, but is still below its level in June.


And it's way, way below its level in either the crisis of late 2008 or the last debt ceiling showdown of August 2011.


Other measures of market fears tell a similar story: Yeah, markets don't love the direction things are going in Washington, but nobody is panicking. The fact that a government shutdown in and of itself hasn't caused big swings in stock and bond markets is no surprise -- the 1995 government shutdowns caused barely a ripple.

But it's a little odder that there is only the barest hint that the investors who drive markets are pricing in a meaningful risk that the government will default on its obligations (in the event Congress refuses to raise the debt ceiling by roughly Oct. 17), or that such an event could cause major damage to the economy. John Makin of the American Enterprise Institute argued in an article this week that the seeds of a recession in 2014 are being planted now, in part by the debt standoff. But there is no sign that the hedge funds and other money managers with billions on the line agree with him.

The Obama administration appears distressed by the paradox. On Thursday, for example, the Treasury Department issued a report titled "The Potential Macroeconomic Effect of Debt Ceiling Brinksmanship" that really could have been titled "What's wrong with you people! Run for the hills!" It is full of charts showing how disastrous the last debt ceiling showdown, in August 2011, was for markets and the economy: Consumer and business confidence measures plummeted, and the premium that businesses and homeowners had to pay to borrow money skyrocketed.


Source: Treasury Department

The president even said as much in an interview with CNBC this week, that "this time I think Wall Street should be concerned," and, "It is important for [Wall Street] to recognize that this is going to have a profound impact on our economy and their bottom lines, their employees and their shareholders." Translation: What's wrong with you people? Why aren't you freaking out at least a little?

In the last five days, the Washington rhetoric has gotten more heated, the irreconcilable negotiating positions of the relevant parties more entrenched  (Republicans: We won't fund the government and raise the debt ceiling until you negotiate with us on Obamacare. Obama: I am not negotiating on Obamacare until you stop threatening to blow up the world). The president essentially needs a market flipout to force external pressure on Republicans that mere presidential oratory and a government shutdown haven't been enough to produce.

But you don't become a hotshot hedge fund trader by making bets based on what "ought" to happen or what seems to make sense on some academic level. You only make money if you guess the direction of markets correctly. And if this standoff ends not with a bang but a whimper (the whimper of 50 or 60 House Republicans joining with House Democrats to pass clean laws to fund the government and raise the debt ceiling on or about Oct. 17), then the current prices in asset markets will look about right.

But the thing to remember is this: Market sentiment can barely move for a very long time -- and then take a dramatic shift all at once. There were warnings that Lehman Brothers could collapse throughout the summer of 2008, but only after its bankruptcy on Sept. 15 of that year did the financial world come unglued.  In 2011, the warnings that the debt ceiling negotiation could get ugly had been sounded for months -- but only turned into an extraordinary bout of volatility about a week before the bill came due for the U.S. government.

Markets are prescient, in other words, except when they're not.

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Ezra Klein | October 4, 2013