The House and presumably the Senate have finished a last-minute deal to increase the debt limit. While it doesn't provide structural reform or much in the way of spending cuts, we think it is otherwise a better-than expected outcome for financial markets.
It should strengthen the dollar temporarily, lift equities and start the process of moving bond yields up toward more normal levels. U.S. GDP growth and developments in Europe (particularly EU steps to counter the procyclical interaction between short selling, derivatives and ratings downgrades) are important remaining variables in the strength of the asset reallocation from bonds to equities.
Good outcome for financial markets:
- The debt limit deal reduces spending growth a bit and leaves open the possibility of constructive reductions at year-end (and a slim chance of the deep structural reforms the U.S. needs to grow faster.)
- The deal may be enough to preserve the U.S. AAA credit rating. Though S&P asked for $4 trillion in deficit reduction, we think it was more in the nature of encouragement to negotiators than an ultimatum. The IMF was doing the same. Many market participants are positioned for a downgrade and are hoping S&P can be pushed into one soon. However, the combination of this deal along with the spending cuts on the continuing resolution earlier this year is an improvement on the Administration's February blowout budget which didn’t cause downgrade warnings -- making it hard to justify a ratings downgrade now.
- The deal avoids a partial shutdown of federal payments next week (perhaps using a short-term bridge in debt authority to give time for drafting the final bill.) A shutdown of payments would have created big uncertainties regarding legal authorities, lawsuits and legal precedents. The number two House Democrat, Congressman Steny Hoyer, was calling for the Administration to use the 14th amendment to keep issuing debt. We don't think that was ever a real consideration by the Administration, but it gives a sense of the legal chaos that might have occurred next week and was getting priced into financial markets.