Markets And The Debt Ceiling: This Time It's Different

The October 17 U.S. debt ceiling deadline is quickly approaching. But markets have been largely unfazed by what many experts warn could be economic catastrophe.

The conventional wisdom has been that lawmakers understand the higher stakes of the debt ceiling and will surely prevent the country from self-inflicted economic trauma.

And considering the fiscal brinksmanship of recent years, it's understandable why investors appear to be unusually complacent.

But are they being too complacent?

"This is anecdotal, so ultimately worthless - but I can't help noticing that everyone saying shutdown/ceiling not a reason to sell stocks," tweeted Matt Busigin on Sunday. "That is the opposite of what I saw during the last debt ceiling and government shutdown talks. Which may mean it's not priced in, and untrue."

"[Investors] believe that - as in the past - the fiscal showdown will end with a midnight compromise that avoids both default and a government shutdown," warned Nouriel Roubini on September 1. "But investors seem to underestimate how dysfunctional U.S. national politics has become. With a majority of the Republican Party on a jihad against government spending, fiscal explosions this autumn cannot be ruled out."

As we now know, the government failed to avoid the shutdown.

The degree of investor complacency may be best captured in government-exposed stocks. In a recent report, Goldman Sachs' Robert Boroujerdi noted "We estimate that little or no volatility premium for the debt ceiling debates is priced into the options markets on stocks most exposed to government spending cuts."

"Complacency is even more pronounced on stocks with high government exposure," he added. "Fear priced into options on these stocks dropped over the past few months to new lows vs. SPX options."

As you can see in the chart above, the cost of put options - which protect investors from sell-offs - for government-exposed stocks recently fell to post-crisis lows. And this time period included at least four post-crisis budget bouts.

The message of complacency is less obvious when you look at the market as a whole. Today, the Volatility Index (VIX) jumped 15%. Still, it continues to be below recent highs. And the S&P 500 is just 2.8% below its September 18 all-time high.

"[W]e believe there is a zero percent chance of a federal government default at that time," said Morgan Stanley's Vincent Reinhart. "The US government will pay its bills."

In a note to clients on Friday, Deutsche Bank's David Bianco wrote that he too saw a zero percent chance that the debt ceiling debate reaches the point where Treasury actually runs out of money and starts missing interest payments.

The language from Wall Street's experts reflect absolute certainty that the U.S. will survive the ongoing debate over the debt ceiling.

However, "zero percent" is the type of language that should set off warning sirens.

Interestingly, Bianco estimated that should the zero-percent scenario occur, the S&P 500 could crash to 850, about a 50% drop.

What's frightening about Bianco's forecast is not the scale of the decline. Rather, what's frightening is that he would go out of his way to present a scenario that had a "zero percent" chance of happening. Because zero represents an impossibility, in theory it couldn't qualify as a worst-case.

If this really had a "zero percent" chance of happening, then there would be no need for Goldman Sachs to write:

If the debt limit is not raised before the Treasury depletes its cash balance, it could force the Treasury to rapidly eliminate the budget deficit to stay under the debt ceiling. We estimate that the fiscal pullback would amount to as much as 4.2% of GDP (annualized). The effect on quarterly growth rates (rather than levels) could be even greater. If this were allowed to occur, it could lead to a rapid downturn in economic activity if not reversed very quickly.

It seems pretty clear that complacency is unusually high, which makes us even more worried that we could have an accident in Washington.

Hopefully, this time isn't different.

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A closer look at the last four fiscal incidents show that "not all fiscal deadlines are created equal." That was the message of Goldman Sachs' Alec Phillips.

Fiscal issues aside, other "unknown unknown" events in American history have spurred market sell-offs. It took the Dow Jones Industrial Average 309 days to crawl back from its lows after Pearl Harbor.

And on the first trading after 9/11, the DJIA fell 684 points, which set a record for biggest loss for one trading day. By the end of that week, the index was down 14.1%.

Recall that the stock market also lost half its value in the months following Lehman Brothers' collapse, prompting a harrowing recession.

Of course, other seemingly monster moments in history - like the crisis at the Fukushima reactor - saw little movements in U.S. markets.

Economically speaking, failure to raise the debt ceiling could rival any of these events. It would of course be doubly silly since that failure would be entirely voluntary.