NEW YORK — Wall Street executives are warning that a debt default would wreck financial markets. But even if President Joe Biden and House Speaker Kevin McCarthy strike a deal, there’s no promise that things will calm down.
A possible downgrade of federal debt — with or without a deal — and growing dissatisfaction with Washington's dysfunction threaten to cloud the outcome even as the White House and Republicans hammer through talks before a June deadline. And with Republicans clamoring for a sharp pullback in government spending, some investors are wary of Biden agreeing to cuts that could hamper his ability to respond to a possible recession.
“There could be some equity market volatility around this,” Mike Reynolds, the vice president of investment strategy at Glenmede, said of the potential for spending cuts in any debt limit deal.
Biden officials argued that a debt ceiling bill passed by McCarthy last month would strain the economy and kill jobs. Now, there's a possibility that the White House might agree to cap spending at a time when markets already face considerable uncertainty amid rising borrowing costs and growing dissatisfaction with the economy.
“I don’t know how exactly how the market’s going to react,” Jenny Johnson, the president and CEO of the mutual fund giant Franklin Templeton, said in an interview at a conference in Manhattan on Wednesday.
The monthslong drama has exasperated financiers already navigating other headwinds.
“It's embarrassing as a country that we get to this point,” Johnson told the audience. While she believes policymakers will reach an agreement and that the U.S. will maintain its dominance over financial markets, the repeated crises are “chipping away” at investor confidence.
That could feed into how Wall Street responds to whatever deal Biden negotiates with GOP leaders.
In some respects, it’s remarkable they haven’t begun to falter. After a wave of failures of regional banks, community and mid-sized financial institutions are starting to pull back from credit markets. Consumer confidence gauges are flashing red. And even as Americans have kept spending money, large retailers and bank card data suggest that they’re starting to reel it in.
Meanwhile, inflation has persisted longer than Federal Reserve Chair Jerome Powell would like. Powell and other Fed leaders have signaled that they’re unlikely to cut interest rates until they’re confident that the price spikes are under control.
That would be difficult terrain for Biden and Republican leaders even in the best of circumstances. But with the federal government just weeks away from tanking Treasury payments on securities used to price everything from mortgages to municipal bonds, they now risk further erosion of the public’s faith in their ability to manage the economy.
The possibility of an economic downshift — with no promise of relief in the form of rate cuts — will bear on how the market receives whatever arrangement Biden and McCarthy make on the debt limit. While McCarthy’s debt ceiling bill included energy-permitting reforms and other changes that would likely cheer markets, it also includes major spending cuts that could spook traders if the economy takes a turn for the worse.
That’s what happened in 2011 after President Barack Obama and Republicans announced a deal only two days before Treasury’s “X-date.”
“It was almost paradoxical, but the equity market, the S&P 500, fell after the debt ceiling passed” in 2011, said Reynolds.
In 2011, stocks started cratering in late July — about 10 days before the Aug. 2 “X-date” — and continued falling until President Barack Obama and Republicans announced a deal on July 31.
The carnage didn’t stop there, however.
Two days after Obama signed the debt ceiling bill, the stock market reported its worst losses since the financial crisis as traders absorbed how the agreement — which forced major spending cuts — would hit an economy that was still stuck in the mud.
On Aug. 5, S&P announced a historic decision to downgrade U.S. sovereign debt, which further pushed down equity markets. Market volatility surged and major indices that track the stock market’s performance didn’t recover until the following year.
Even if Congress sends a debt limit bill to Biden’s desk before June 1, a downgrade — which would drive up credits costs for both governments and consumers — remains a threat.
Richard Bernstein, the former longtime chief investment strategist at Merrill Lynch who now leads an eponymous investment firm, said he now believes the possibility of a downgrade is north of 50 percent. Yellen and other Biden administration officials have raised the specter of the U.S. losing its top-tier credit rating in speeches and meetings with lawmakers.
With that said, the economy is much more resilient than it was following the global financial crisis. Unemployment stands at a fraction of where it was in 2011. Households and businesses were flush with cash as the Fed kicked off rate hikes last year, which gave them a solid cushion to withstand losses as higher borrowing costs took hold.
Just as importantly, while House Republican leaders are pushing for spending cuts now — something leaders have said could help cool inflation — they could easily backtrack if an economic contraction starts to hammer red districts, said RSM US chief economist Joe Brusuelas.
Even if new spending caps are binding, “the current track of negotiations between the White House and the Congress strongly suggests that whatever caps are put in place will not constrain the ability of the fiscal authority to respond to whatever needs arise in case of recession,” he said.
