Political indecision raises long-term risks for US

So far, the markets have not factored in a scenario where the US defaults on its payment obligations after 17 October. But with every passing hour it is becoming apparent that no conclusive deal is likely before or by Thursday. 

 

Fitch Ratings has put the country's sovereign rating on watch. The big question that markets have to deal with is: what happpens if the US does not resolve the debt ceiling issue. Robert V DiClemente and William Lee of Citi have put out four possible scenarios and the implications, therein, in a note dated October 10. 

 

Scenario I (Base Case) 

 

 

Simulating A Balanced-Budget Scenario: Given the fiscal impasse, there’s a greater uncertainty around our base case view of a second-half pickup followed by 3% growth in 2014. We have trimmed 0.3% off our October forecast for Q4 growth (Figure 5) and added the difference back into the first half of next year. This reflects the impact of a longer shutdown than we assumed previously, extending closer to a full month but on a smaller scale because some furloughed workers have been recalled. 

 

A temporary extension (or suspension) of the debt ceiling resolved between October 16 and October 31 would likely weaken financial conditions. However, the experience of 2011 suggests that activity may remain unaffected if sentiment recovers post-resolution.

 

Politics aside, we still judge that the economic fundamentals are more favorable with fewer obstacles to expansion than in 2011 and the Fed remains fully committed to underpinning financial conditions through both QE and aggressive guidance. If borrowing authority is extended by six weeks and a partial shutdown extends into November, that probably would immobilize a data-starved Fed easily into next year.

For now, we have left in place a timetable for Fed tapering to begin in the next few months, with the greatest probability centered on December or January.

 

Nonetheless, the base case remains at the mercy of fiscal deliberations that reflect a surprising willingness on both sides to risk serious harm. 

 

If the debt limit is not resolved before Treasury exhausts cash around end-October or November 1 at the very latest, the chances of greater negative fallout on markets and the economy would rise quickly and significantly. So as with the threat of the fiscal cliff last year, the uncertain path of fiscal policy raises the value of analyzing alternative and more complicated fiscal and market scenarios. 

 

Although the restraint from higher taxes and sequestration are beginning to fade, the risks associated with shutdown and default now dominate but are especially hard to quantify. So the results below are intended as rough first guesses.

In its recent review of the 2011 debt showdown, Treasury noted that “a default would be unprecedented and has the potential to be catastrophic: credit markets could freeze, the value of the dollar could plummet, US interest rates could skyrocket,” and there could be a recession that would replay the crisis of 2008 or worse. We are not going to define a scenario to replicate this outcome.

However, there may be value in scenarios that explore the effects of a massive fiscal shock compounded by severe erosion in financial conditions.

 

Scenario II

 

Technical Default: Based on the experience in 2011, Citi imposes a two sigma event of deteriorating financial conditions (using the Citi FCI). This  incorporates a 25% decline in equity values and a rise in credit spreads that raises mortgage rates by about 100 basis points. 

 

In addition, there would be a massive direct shock to the economy of several hundred billion dollars, due to an automatic pullback in government spending to balance the budget immediately. 

 

To remain true to historical experience captured in the model estimates, we made a less radical fiscal assumption that spending would drop by $220 billion, or not quite what a balanced budget would require. (See discussion of balanced budget non-solution below). 

 

This alternative assumes a technical default in which Treasury runs out of cash and new borrowing authority is delayed, but there is an agreement that restores full government spending and the debt ceiling by yearend. 

 

In this simulation, markets revert back to our base case outlook for moderate growth and modestly accommodative financial conditions. In our simulation, the financial hit alone has a lagged effect that mainly dampens growth early in 2014. But the sudden fiscal drag crushes growth immediately. 

 

Compared to the base case, growth is down 6½% in the fourth quarter, more than enough to arrest even an improving economic expansion. This outcome implies the unemployment rate jumps toward 8% in the first half of 2014. 

 

The fact that government spending is restored in the first quarter and markets rebound, means that this shock has no lasting effects on growth. Our simulation shows that growth quickly returns to the base case in the first half and by the second half of 2014 growth is significantly higher as the economy catches up to the previous trend.

 

Scenario III 

 

Extended Impasse: In this case, the debt ceiling is binding for an extended period (and as discussed below, a virtually unworkable outcome in reality and only possible in the abstract), and is much more damaging to the economy. 

 

In that case, financial markets do not recover their losses and the cuts in government spending remain in place. The permanent market hit alone causes a loss of growth in 2014 of more than 2 percentage points. Beyond that, the permanent reduction in government spending causes a full-blown recession. 

 

Economic activity contracts for three consecutive quarters (starting now), and over a four-quarter span GDP would decline by 2.7%. The unemployment rate rises to about 9½% by the end of 2014.

 

Scenario IV 

 

Delayed CR, Lasting Financial Damage: Our last scenario allows for the resolution of the fiscal deadlock without significant fiscal drag. However, in this case global markets are less forgiving and the cumulative effects of fiscal dysfunction begin to weigh more permanently on financial conditions. 

 

Although this outcome is not our base case, it may be a legitimate foreshadowing of global investors and the public’s growing concern about the medium-term costs of the US’s unsustainable public debt and the lack of focus on structural reforms to produce a viable and credible fiscal framework. On balance, all these alternatives carry important warnings. 

 

First, in all cases, the unemployment rate a year out is considerably higher than it would be otherwise; a half point higher in the least bad outcome. In that scenario, GDP still would be about a full percentage point lower in one year than in our base case for growth. In the more extreme version, GDP is more than five points lower than in the base case and unemployment roughly 3 points higher in a year. 

 

Second, the exercise illustrates (to the extent that historical relationships can predictably capture the channels through which default would operate) the importance of how financial conditions react and settle in the wake of fiscal turmoil. When financial conditions are repaired quickly, the economic damage is contained even where the initial hit from fiscal restraint is severe. The converse also holds where even if fiscal damage is repaired, the recovery may still struggle if financial headwinds persist. 

 

Finally, all of these scenarios illustrate the potentially damaging and immediate effects of imposing a balance budget virtually overnight. In each instance, GDP declines 4% in the first quarter.