Probabilities of Bearish Scenarios Increasing
By James Kostohryz Jul 29, 2011 2:30 pm
The nature of the debt ceiling compromise could be bad for the US economy and markets. And negative scenarios in the US could have ripple effects around the world.
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Developments last night and this morning are highlighting increasing probabilities of negative scenarios unfolding during the next few weeks and months.
Prospects for a Deal
Obama gave a speech on Friday to reassure markets and urge bipartisanship. The tone of the speech was essentially upbeat and highlighted several avenues for compromise.
Separately, reports circulated on Friday that the House may pass John Boehner's proposed plan if a provision is inserted that requires passage of a Balanced Budget Amendment before the debt ceiling is reached again.
The market rallied intra-day on Friday morning on these items. The reason for such optimism is not immediately apparent.
Clearly, a balanced budget amendment provision widens the gulf between the parties. If the House bill was “dead on arrival” in the Senate, the balanced budge provision simply defiles the corpse.
The optimism of the market can only be understood in the following context: Passage of a bill -- any bill -- will kick off a new stage in the negotiations whereby House and Senate leaders will begin the conferencing process to come up with a compromise bill that both the House and Senate can pass. And indeed, history suggests that once in conference, leaders will be able to broker plan that can get enough votes. More so with the gun of default held to their collective heads.
The scenario for a compromise bill is that Boehner agrees to water down the House plan by jettisoning the balanced budget amendment requirement and making a few concessions to bring the joint bill a bit closer to the Harry Reid-sponsored Senate plan that will likely pass Friday afternoon.
The compromise plan that will come out of the House-Senate conference will lose the support of some hardcore Tea Party Republicans in the House, but that will be compensated by the Democratic leadership getting House Democrats to make up the difference. I see few scenarios in which Senate passage will become an impediment. Indeed, I can see a scenario of a compromise bill passing by a wide margin in both chambers of Congress.
Note that under this compromise scenario, Congress will have to approve another increase in the debt limit within six to 12 months. However, immediate default will be averted.
Relief that default may be averted explains the rally Friday morning. Furthermore, the specter is being raised for a relief rally early next week if Congress averts default and a bill is passed, particularly if it is accomplished by a wide margin.
Ominous Clouds Gathering Ahead
Notwithstanding the relief that will be caused by averting default in the short term, I will reiterate what I said yesterday in my article What Would a "Good" Deal on the Debt Ceiling Look Like?: Any deal that does not take the debt ceiling out of play for 18 months is going to be bad for the economy and for the market. I do not believe that the economy or markets can make any headway in the face of continual bickering, grandstanding, and imminent threat of default
Unfortunately, as described in the fist section of this article, the probabilities of getting a "bad" deal are more than 50% and rising. Indeed, last night’s and this morning’s developments have greatly increased those probabilities.
Another factor needs to be accounted for. Given the time constraints, the probabilities of no deal by the August 2 deadline are rising significantly. While this does not imply default, it raises the specter of the government delaying and/or withholding payments to suppliers, entitlement holders, and etc. Talk about reverse fiscal stimulus! Thus, while the probability of this fiscal retrenchment scenario is probably still below 50%, the probabilities are rising extremely fast. And this is a development which — if it drags on for more than a week or so -- could break the back of the feeble economic expansion.
Prospects for a Deal
Obama gave a speech on Friday to reassure markets and urge bipartisanship. The tone of the speech was essentially upbeat and highlighted several avenues for compromise.
Separately, reports circulated on Friday that the House may pass John Boehner's proposed plan if a provision is inserted that requires passage of a Balanced Budget Amendment before the debt ceiling is reached again.
The market rallied intra-day on Friday morning on these items. The reason for such optimism is not immediately apparent.
Clearly, a balanced budget amendment provision widens the gulf between the parties. If the House bill was “dead on arrival” in the Senate, the balanced budge provision simply defiles the corpse.
The optimism of the market can only be understood in the following context: Passage of a bill -- any bill -- will kick off a new stage in the negotiations whereby House and Senate leaders will begin the conferencing process to come up with a compromise bill that both the House and Senate can pass. And indeed, history suggests that once in conference, leaders will be able to broker plan that can get enough votes. More so with the gun of default held to their collective heads.
The scenario for a compromise bill is that Boehner agrees to water down the House plan by jettisoning the balanced budget amendment requirement and making a few concessions to bring the joint bill a bit closer to the Harry Reid-sponsored Senate plan that will likely pass Friday afternoon. The compromise plan that will come out of the House-Senate conference will lose the support of some hardcore Tea Party Republicans in the House, but that will be compensated by the Democratic leadership getting House Democrats to make up the difference. I see few scenarios in which Senate passage will become an impediment. Indeed, I can see a scenario of a compromise bill passing by a wide margin in both chambers of Congress.
Note that under this compromise scenario, Congress will have to approve another increase in the debt limit within six to 12 months. However, immediate default will be averted.
Relief that default may be averted explains the rally Friday morning. Furthermore, the specter is being raised for a relief rally early next week if Congress averts default and a bill is passed, particularly if it is accomplished by a wide margin.
Ominous Clouds Gathering Ahead
Notwithstanding the relief that will be caused by averting default in the short term, I will reiterate what I said yesterday in my article What Would a "Good" Deal on the Debt Ceiling Look Like?: Any deal that does not take the debt ceiling out of play for 18 months is going to be bad for the economy and for the market. I do not believe that the economy or markets can make any headway in the face of continual bickering, grandstanding, and imminent threat of default
Unfortunately, as described in the fist section of this article, the probabilities of getting a "bad" deal are more than 50% and rising. Indeed, last night’s and this morning’s developments have greatly increased those probabilities.
Another factor needs to be accounted for. Given the time constraints, the probabilities of no deal by the August 2 deadline are rising significantly. While this does not imply default, it raises the specter of the government delaying and/or withholding payments to suppliers, entitlement holders, and etc. Talk about reverse fiscal stimulus! Thus, while the probability of this fiscal retrenchment scenario is probably still below 50%, the probabilities are rising extremely fast. And this is a development which — if it drags on for more than a week or so -- could break the back of the feeble economic expansion.
Increased Perceptions Of Economic Vulnerability
The GDP data released on Friday for the first and second quarter of 2011 are of little relevance for forecasting the economy in the second half.
However, the fact that the economy was substantially weaker in the first half of 2011 than economists had estimated, highlights the fact that the economy is barely moving along at “stall” speed. This will tend to increase fears in the market that any disruption to the confidence of business leaders, consumers and investors could bring the economy below “stall” speed and occasion a nose dive into recession.
Thus, the GDP reports on Friday bring an additional risk factor into play that wasn’t there last week. Heightened perceptions of macroeconomic risk constitute a factor that increase the probabilities of bad macroeconomic and market outcomes.
International Risks Heightened
Lost in the news shuffle is the fact that the situation in Europe is not getting any better. And the debt ceiling circus in the US is clearly not helping.
A scenario in which the US and global growth decelerates and credit conditions tighten in fixed income and money markets could be the catalyst that pushes the European crisis into a new phase.
Thus, it should be kept in mind that the debt ceiling shenanigans in the US are significantly increasing the probabilities of negative outcomes in Europe.
The probability of negative outcomes in China are also rising. China’s economy is highly dependent on exports to Europe and the US. China was able to avert recession in 2008-2009 thanks to a massive monetary and fiscal stimulus program. For various reasons that cannot be elaborated on here, their ability to counteract a recessionary scenario in Europe and/or the US will be more limited this time around.
I am not predicting crises around the world. It is too early for that. I am merely pointing out the probabilities of international crises are rising. This argues, at the very least, for caution towards equities on a world wide basis.
Conclusion
A deal on the US debt ceiling that averts short-term default is the most likely scenario. Markets may briefly rally briefly -- perhaps sharply -- in relief.
However, looking forward a few weeks and months, probabilities are rising that the nature of the debt ceiling compromise that will emerge will be bad for the economy and markets in the US. And any negative scenarios in the US are likely to have ripple effects around the world.
Given this outlook, probabilities are rising that key technical supports will come into play in within the next few weeks (possibly days). The 200-day moving average of the S&P 500 is at around the 1280 area. A key horizontal band of support going back to June and April of 2011 comes into play between 1265 and 1255.
Under my definition of a “bad agreement” I believe that these supports would be ultimately be violated. As such, probabilities are rising that the US equity market will enter into a bearish cyclical phase.
How deep could the correction be? I will not venture a guess until after seeing what sort of debt ceiling deal emerges.
I remain long ^SPX puts and long VXX as my favored vehicles to play a scenario of increasing probabilities of negative scenarios.
The GDP data released on Friday for the first and second quarter of 2011 are of little relevance for forecasting the economy in the second half.
However, the fact that the economy was substantially weaker in the first half of 2011 than economists had estimated, highlights the fact that the economy is barely moving along at “stall” speed. This will tend to increase fears in the market that any disruption to the confidence of business leaders, consumers and investors could bring the economy below “stall” speed and occasion a nose dive into recession.
Thus, the GDP reports on Friday bring an additional risk factor into play that wasn’t there last week. Heightened perceptions of macroeconomic risk constitute a factor that increase the probabilities of bad macroeconomic and market outcomes.
International Risks Heightened
Lost in the news shuffle is the fact that the situation in Europe is not getting any better. And the debt ceiling circus in the US is clearly not helping.
A scenario in which the US and global growth decelerates and credit conditions tighten in fixed income and money markets could be the catalyst that pushes the European crisis into a new phase.
Thus, it should be kept in mind that the debt ceiling shenanigans in the US are significantly increasing the probabilities of negative outcomes in Europe.
The probability of negative outcomes in China are also rising. China’s economy is highly dependent on exports to Europe and the US. China was able to avert recession in 2008-2009 thanks to a massive monetary and fiscal stimulus program. For various reasons that cannot be elaborated on here, their ability to counteract a recessionary scenario in Europe and/or the US will be more limited this time around.
I am not predicting crises around the world. It is too early for that. I am merely pointing out the probabilities of international crises are rising. This argues, at the very least, for caution towards equities on a world wide basis. Conclusion
A deal on the US debt ceiling that averts short-term default is the most likely scenario. Markets may briefly rally briefly -- perhaps sharply -- in relief.
However, looking forward a few weeks and months, probabilities are rising that the nature of the debt ceiling compromise that will emerge will be bad for the economy and markets in the US. And any negative scenarios in the US are likely to have ripple effects around the world.
Given this outlook, probabilities are rising that key technical supports will come into play in within the next few weeks (possibly days). The 200-day moving average of the S&P 500 is at around the 1280 area. A key horizontal band of support going back to June and April of 2011 comes into play between 1265 and 1255.
Under my definition of a “bad agreement” I believe that these supports would be ultimately be violated. As such, probabilities are rising that the US equity market will enter into a bearish cyclical phase.
How deep could the correction be? I will not venture a guess until after seeing what sort of debt ceiling deal emerges.
I remain long ^SPX puts and long VXX as my favored vehicles to play a scenario of increasing probabilities of negative scenarios.
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