July 25, 2011 / 9:55 PM / 9 years ago

Debt talks rivet Wall St; calm before the storm?

 By Steven C. Johnson
 NEW YORK, July 25 (Reuters) - Gradually, then suddenly.
 Ernest Hemingway's description of how a man goes broke may
sum up how investors could react if the United States fails to
raise the debt ceiling by Aug. 2 to stave off default.
 While stocks, Treasuries and the U.S. dollar slipped on
Monday as it became clear the debt ceiling debate would go down
to the wire, there was no sign of the panic some had feared.
 But next Monday, one day ahead of the critical deadline,
market reaction could be swift if lawmakers are still far from
a deal, investors and analysts said. That's when the prospect
of a U.S. default and ratings downgrade could really sink in.
 "Nobody is going to believe the U.S. will actually stop
paying its bills until that happens," said Hugh Johnson, chief
investment officer at Johnson Illington Advisors in Albany. "So
I think it we'll have to hit the wall" before markets panic.
 Say what you will about Wall Street, but it has been
consistent throughout the summer's debate. Investors have long
predicted Republicans and Democrats would go down to the wire
before agreeing to raise the $14.3 trillion borrowing limit.
 "We really have to get right on top of the deadline," said
Nick Kalivas, senior equity analyst at MF Global. "Come Monday,
there will probably be a more significant reaction. My guess is
that's when people will get really concerned."
 Many still think a deal will be done, even though agreement
on a long-term deficit reduction plan -- a Republican-mandated
prerequisite for raising the debt ceiling -- appears far off.
 For more, see [ID:nN1E76N0CA]
 "Markets will be forgiving until they give up on reaching a
compromise," said Richard Bernstein, chief executive at Richard
Bernstein Advisors. "Even leading up to the (bank bailout) vote
in 2008, markets gave Washington the benefit of the doubt until
they managed to completely mess it up."
 That's the rub. When Congress failed after Lehman Brothers'
2008 collapse to authorize a $700 billion bailout for troubled
banks, world markets sold off violently.
 If the United States were to default and ratings agencies
cut its prized AAA credit rating, investors fear a repeat of
that sort of market chaos.
 A downgrade could ripple through markets because Treasuries
are considered the world's "risk-free" asset on which countless
other asset prices are based. The dollar, stocks, municipal
debt and risky overseas assets could suffer collateral damage.
 "We could see a shock, but I would think it would come on
Aug. 2 or 3," said Peter Demirali, portfolio manager at
Cumberland Advisors in Vineland, New Jersey, with $1.8 billion
under management. "I don't think they will sell off earlier
unless somebody comes out and drops a bomb and says we're going
home for good."
 COUNTDOWN TO AUG. 15?
 Some analysts say Wall Street may also be betting that Aug.
2 is a soft deadline. In a note to clients, Barclays Capital
analysts said stronger-than-expected tax receipts since July 14
"suggests the date on which the Treasury will run out of cash
to pay its obligations might be around Aug. 10 instead."
 That would only provide a bit of breathing room, however,
since Treasury faces $25.6 billion in quarterly interest
payments on coupon-bearing Treasuries by the middle of August.
 "We've got a lot of coupon payments on Aug. 15, that's
really the date we need to watch," said Priya Misra, rates
strategist at BofA-Merrill Lynch.
 She said Treasury can make debt maturity payments up to
that date, but "Aug. 15 is when they either prioritize or
miss.
 "If they miss coupon payments we know exactly what the
securities are," she said. "The price of the securities would
move drastically that day and you would see a tiering. The next
coupon securities would start underperforming much sooner."
 Kalivas said he was watching the rates on bills with
payments due in early August for signs of stress. Treasury was
forced to pay higher rates on fresh three- and six-month bills
sold on Monday. He said sales for two-, five- and seven-year
debt would also be watched for foreign participation.
 "If dealers are having to buy more of this than what we've
been seeing the markets might get concerned," he said.
 SPOOKING THE STOCK MARKET
 But it might not be bonds that get hit hardest. A Standard
Chartered report showed that when deadlock over the debt
ceiling forced the U.S. government to close down in 1995,
yields fell while stocks suffered on concerns about growth.
There was no real concern in the market at that time, however,
that the United States might fully default.
 Jane Caron, who helps manage $53 billion at Dwight Asset
Management in Burlington, Vermont, said stocks may be the
canary in the coal mine this time, too.
 "Those who wanted to raise cash and get out of the long end
of the bond market have done that already, so you don't want to
chase that trade now," she said. "You could get whipsawed if
they reach a deal at the last minute."
 "What I'm watching is the equity market because I think
investors there are more inclined to get spooked this week,"
she said, adding, ironically, that a move out of stocks would
probably boost shorter-dated Treasuries.
 Currency strategists said the dollar would likely hold up
until it was absolutely certain that a deal would not be
reached by Aug. 2.
 While a default or a downgrade would push the dollar lower
against safe havens such as the Swiss franc, Europe's own debt
problems might keep the dollar fairly well supported against
the euro, said Firas Askari, head of trading at BMO Capital
Markets.
 "The spectacular lack of statesmanship and increased amount
of brinkmanship in the U.S. sure aren't encouraging," he said,
"But I am even more worried about the euro right now."
 (Additional reporting by Karen Brettell; editing by Leslie
Adler)


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