July 19, 2011

By Ted Wieseman | New York

Continued turmoil in Europe, soft domestic economic data that continued to portray an increasingly poor 1H, and a strong run of 3-year, 10-year and 30-year auctions in dramatic contrast to the very poor 2-year, 5-year and 7-year sales in the last week of June boosted Treasuries to solid gains over the past week, moving yields in the short and intermediate parts of the curve back down towards the lows for the year hit three weeks ago.  The debt ceiling/deficit reduction negotiations turning into what seems to be acrimonious partisan debate and Moody's and S&P both warning about the possibility of an imminent downgrade of the AAA US sovereign rating became an increasing focus of investors through the week - and along with developments in Europe, will likely continue to dominate market focus in the coming week - but market impact to this point has been limited.  While there were brief bouts of general Treasury market weakness in response to the announcements from Moody's and S&P, the key impact for the week overall was notable underperformance by the long end and a rise in long-term inflation expectations rather than, to this point, any general impact on the level of rates.  The Moody's warning focused on the very small, but in its view no longer ‘de minimis', risk of an actual short-term default caused by the debt ceiling.  S&P, on the other hand, indicated that it believes that a major breakthrough on reducing the long-term deficit outlook is needed within three months to preserve the AAA US sovereign rating.  Odds of such an agreement being reached in the short term seem to be falling.  There has been a major shift in Washington this year towards broad bipartisan agreement that the deficit must be reduced sharply over the next decade and the debt/GDP ratio stabilized.  How to get there remains subject to vigorous debate and strong partisan disagreement, but we view as quite encouraging on a medium-term view the fact that the debate is now over how, not whether, to cut the deficit enough to stabilize the debt/GDP ratio.  And while without action the long-term debt outlook starts to become deeply concerning over the next decade, at only about 65% of GDP currently, the federal government debt/GDP ratio is not now at a problematic level at all, in our view.  So, we think that S&P's insistence that a deal be reached in three months is very short-sighted, but if it sticks to the view that a major long-term deal must be reached that quickly, then odds of a downgrade, mistaken as it might be, in our view, would certainly seem to be on the rise.



The bulk of the week's Treasury market gains came Monday, driven by continued heavy pressure in Italian markets as the crisis in Greece seemed to be spreading into broader systemic worries about the EMU, causing a substantial flight-to-safety rally in Treasuries.  While US market attention shifted somewhat back to domestic concerns about the economy and the fiscal situation over the course of the week, there was little relief in Europe stresses, with only a small improvement after bank stress-test results were released Friday.  Italy remained the key focus, and in late trading Friday, its 5-year CDS was trading near a record 305bp after about a 50bp widening on the week.  The EMU peripheral also remained under heavy pressure, with Spain's 5-year CDS widening about 40bp to near 350bp, Ireland 230bp to 1,120bp, Portugal 240bp to 1,140bp, and Greece to a 50-point upfront charge, up 2.5 points.  Domestically, weak results from the international trade report for May and retail sales report for June pointed to even slower 1H growth, while another upside surprise extended the rapid acceleration in core inflation.  We now see 2Q GDP tracking at 1.9% instead of +2.6%, while there is a rising likelihood that core PCE inflation could move above the top of the FOMC's 1.7-2.0% target range at year-end.  Although Fed Chairman Bernanke's semi-annual monetary policy testimony was somewhat more dovish than expected, such a trajectory for core inflation would likely still raise a high bar for additional easing even if the soft patch were to persist into 2H.
In addition to the crisis in Europe and softer-than-expected US growth data, it seems that investors are finally starting to focus much more closely on the debt ceiling fight in the US.  After a couple of days of surprising signs of hope at the end of the prior week after reports that President Obama and House Speaker Boehner had agreed in principle to a 10-year $4 trillion deficit reduction plan to attach to a debt ceiling increase, partisan deadlock has quickly returned as the clock continues ticking towards the August deadline.  That $4 trillion number is an important benchmark, because we estimate (see US Economics: Is a Debt Ceiling Deal on the Horizon? July 7, 2011) that a reduction in the deficit relative to the CBO baseline of about that much over ten years would be needed to stabilize the total federal debt to GDP ratio near 70% in 2021 compared to near 60% at the end of fiscal 2010 (which is about 50% Treasuries and 10% non-market debt-like savings bonds and SLGS).  With no change to the baseline, the debt/GDP ratio would likely be over 100% of GDP - and rising - in ten years.
Early the past week, Republican Senate Minority Leader McConnell proposed a three-stage plan that would require the president to announce a series of planned budget cuts that would allow a series of shorter-term debt ceiling increases, maybe creating some sort of avenue for compromise.  And Friday's news that House Republicans plan to approve a debt ceiling increase/deficit reduction plan in the coming week briefly lifted market hopes that a debt ceiling agreement might be nearer. The ‘cut, cap and balance' plan that the House will vote on slashes F2012 spending by $111 billion, cuts federal spending as a share of GDP to below 20% over the next few years (near the long-term average) from almost 24% this year, and requires passage of a balanced budget amendment to the constitution by Congress that caps federal spending at 18% of GDP as a condition for raising the debt ceiling.  The House Republican plan will most likely receive no consideration in the Democratic-controlled Senate, so the vote seems to represent a hardening of the partisan divide more than any progress towards a compromise.  The McConnell plan also seems unlikely to gain much traction, in our view, since it seems to be designed to force President Obama to identify specific cuts in popular programs and subsequently take the blame for not following through on those cuts.  So, the President would wind up taking the political heat from both sides.  We continue to see very little risk of any actual missed interest payment or other short-term debt default.  But it appears we may be heading towards a deal built more on less substantive or unenforceable provisions than real, enforceable deficit reduction.  With S&P warning that a plan implementing the $4 trillion needed to stabilize the debt to GDP ratio must be reached (or be very close to being reached) within the next several months to maintain the US's AAA rating, and chances of such a comprehensive deal seemingly declining, risks of a downgrade - unjustified as it would be at this point, in our view - appear to be rising.